Self-Employed Debtors: The Bankruptcy Means Test Dilemma

When Congress amended the Bankruptcy Code in 2005, one of the biggest changes was the addition the "means test" to create objective standards for determining which individuals are "abusing" the privilege of filing for relief in a Chapter 7 bankruptcy. The test only applies to individuals with primarily consumer debts (as opposed to business debts) and begins with a review of the debtor's average income for the past six months to determine the debtor's approximate income.

If the debtor's income is below the median income for households of the same size where the debtor lives ($77,014 for a household of 4 in California), then the debtor "passes" the means test and is eligible for Chapter 7 bankruptcy. Debtors who earn above the median must go a through an analysis to calculate the debtor's ability to fund a Chapter 13 repayment plan.

For most debtors, the income documentation comes from their paychecks stubs. The income and mandatory deducts for items like taxes and FICA are easy to identify and analyze. But what about self employed debtors?

For debtors who are self employed/sole proprietor, as a general rule, the bankruptcy trustee is interested in the net income of the business, which consists of gross income of the debtor's business minus necessary business expenses. This usually requires completion of a Profit and Loss Statement showing gross income and gross expenses for the six (6) months prior to case filing, with enough specificity to allow the Trustee to fully analyze the business. Surprisingly, many business owners do not know how to produce a Profit and Loss Statement.

Small business owners should use an accounting program such as QuickBooks or Microsoft Money. The business owner should track their expenses with the same level of detail that might be used when applying for a mortgage or completing a tax return. The more legitimate business expenses that that the business owner can document, the easier it is to pass the means test.

Some business owners resist this requirement due to the time required or the potential cost if they require assistance from a bookkeeper or an accountant. However, the fiscal discipline necessary to produce proper financial statements is often required for a small business owner to succeed. Most Chapter 7 debtors really have no idea where their money goes, which is often the source of their financial difficulties. Being able to properly track income and expenses is the first step to helping a struggling business owner take control and get the full benefit the fresh start from a discharge in bankruptcy.

If you are located in Southern California and have additional questions about bankruptcy or need further assistance, please contact us.

About the Author: Carl H. Starrett II has been a licensed attorney since 1993 and is a member in good standing with the California State Bar and the San Diego County Bar Association. Mr. Starrett practices in the areas of bankruptcy, business litigation, construction, corporate planning and debt collection.