Considering - or coping with - bankruptcy

Bankruptcy reform is now the law of the land, bringing good and bad news for veterinarians.

The upside is that fewer clients – animal owners, suppliers, fewer individuals overall – are filing for bankruptcy these days because of tighter restrictions.

The downside is that it's now much more difficult – and expensive – for any financially troubled veterinarian, veterinary practice or small business to use bankruptcy as a safe harbor during recovery, or to collect money from clients who still do seek bankruptcy protection.

Individual bankruptcy filings in the federal courts dropped 70 percent in 2006, the first full year after the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, the first major reform of the bankruptcy laws in more than 25 years.

According to the Administrative Office of the U.S. Courts, filings involving predominantly business debts totaled 19,695 last year, down 50 percent from the 39,201 business bankruptcies filed in 2005.

Congress passed the reform legislation in response to years of complaints from lending institutions and creditors that too many financially irresponsible people were abusing bankruptcy laws, rather than honestly attempting to pay their debts.

How bankruptcy works

Bankruptcy proceedings begin with the filing of a petition in bankruptcy court. That immediately creates a bankruptcy estate, containing all of the individual's or firm's assets.

As under the former bankruptcy laws, the two principal types of legal bankruptcy are: Chapter 7, or involuntary, where one or more creditors petition to have a debtor judged insolvent by a court; and Chapter 11, or voluntary, when the debtor brings the petition.

As before, the objective is an orderly and equitable settlement of obligations. But the new legislation takes a much harder line.

Generally, when a debt is canceled, the forgiven amount is considered taxable income for the debtor. If a debt is canceled under bankruptcy, however, it is not taxable income, though it does reduce the amount of other tax benefits to which the debtor might otherwise be entitled.

Under bankruptcy proceedings, higher-priority claims are paid in full before those ranked lower in priority receive anything. The order of payment is as follows:

(1) Claims for debts to a spouse or children for court-ordered support.

(2) Administrative expenses of the bankruptcy.

(3) Unsecured, post-petition claims in an involuntary case.

(4) Wage claims of employees and independent salespersons up to $4,300 per claim.

(5) Contributions to employee benefit plans up to $4,300 per employee.

(6) Claims of farmers and fishermen against debtors operating storage or processing facilities.

(7) Layaway claims of individuals who did not get the item on which they made the deposit.

(8) Recent income, sales, employment or gross-receipts taxes.

(9) Commitments to maintain the capital of a bank or savings and loan firm.

Secured claims are paid from the proceeds of the collateral; if collateral is insufficient to pay a claim in full, the balance becomes an unsecured claim.

Even creditors have options

All too often, veterinarians who are notified that a client or supplier filed for bankruptcy assume the practice has few rights or options. That is not true.

For example, creditors may share in any distribution from a bankruptcy estate, usually depending on the priority of their claims. Under reformed bankruptcy laws, creditors also have the right to be heard in court regarding the payment plan and the liquidation of the debtor's non-exempt assets.

More importantly, a creditor may challenge a debtor's right to discharge the debt owed the creditor. In other words, creditors can voice their opinions about debts that might or might not be forgiven. They also can argue about assets that, perhaps, should have been included in the bankruptcy estate.

When notified of a client's bankruptcy, the veterinary practice should immediately cease any collection action. The debtor has an automatic stay from such action.

The practice should, however, promptly file proof of a claim, as filing deadlines are strictly enforced.

So-called "secured" creditors are at the top of the payback list and have specific rights to the property that is the collateral for their claim.

They also have the best chance of getting relief from the automatic stay, and of receiving "adequate protection payments" to prevent a decline in the equity available to secure their claims.

Whether the veterinary practice is a secured or unsecured creditor, the best deterrent to abuse of the bankruptcy system is creditor vigilance.

Creditors are entitled to question the debtor under oath about assets, liabilities and financial history at the first meeting of the creditors. Also, keep in mind that some bankruptcies are dismissed because of the debtor's failure to comply with legal requirements. When that happens, creditors may pursue collection according to state law.

Sometimes cases originally classified as "no asset" cases blossom into asset cases from which a dividend may be paid. Be vigilant.

Is bankruptcy an option?

Owners and managers of troubled veterinary practices sometimes must decide whether bankruptcy is the right course for them.

Remember: Corporations, limited-liability companies and partnerships are legal entities separate from their shareholders or partners. They can seek bankruptcy protection in their own right.

Sole proprietorships, however, usually are an extension of the veterinarian and therefore cannot file bankruptcy alone, so the practitioner must do so.

Designation as an S corporation is a matter of tax law, having little to do with the kind of legal entity the corporation is. Watch out, however, if the S corporation files bankruptcy. Any taxable income generated after the bankruptcy may still be taxable to the shareholders, since the corporation is not a tax-paying entity. Think of those forgiven debts as income.

When it comes to a partnership in a Chapter 7 bankruptcy, the trustee can sue the general partners if the assets are insufficient to pay all claims to the amount by which the partnership's assets fall short of its debts.

As a result, partners may be facing a suit by a well-funded trustee suing for the benefit of all creditors of the partnership.

Would the veterinary practice benefit from a reorganization, or should it be liquidated?

Reorganization cannot create a market, increase practice revenue or make up for a poor fit between the skills available and the skills required to operate the practice.

Reorganization under bankruptcy laws could, however, permit funds that are servicing old debt to be redirected to current operations. It could permit rejection of restrictive or expensive leases or contracts that are no longer advantageous. Or it could prevent the loss of vital assets or cash to a creditor.

This relief could go a long way toward paying taxes or unpaid salaries, while sale of the practice could provide ongoing jobs for employees under new ownership.

What's in your future?

Generally, practices or businesses that require little capital, have few assets or are merely extensions of the owner's skills and personality are ones that may not benefit much from reorganization. The owners might be better off liquidating, in or out of bankruptcy, and beginning anew with a fresh entity.

A Chapter 7 bankruptcy, whether for an individual or a corporation, often is the best choice when:

• The practice or business clearly has no future.

• The practice has no substantial assets, or has inherent qualities that cannot be reproduced after bankruptcy.

• The debts are so overwhelming that restructuring them is not feasible.

Bankruptcy reform is just beginning to make an impact. Despite the stricter rules, bankruptcy remains an option and, all too often, a reality that both individuals and practices may have to face.

Mark E. Battersby is a financial consultant in Ardmore, Pa.