Case Study: Small Business Failure & Solution

A turnaround scenario from the frontlines of insolvency

This case study is an aggregated (fictional, but very real) scenario from what we see in our daily practice. It’s a small business situation, with typical small business challenges, mistakes and debt. It is illustrative of how debt can accumulate and get away on a small business owner who has very little if any professional accounting or professional help. They are usually very good at what they do but not at all adept at administration.

When we meet with people in these situations, they typically end up filing an insolvency proceeding – either a bankruptcy or a consumer proposal. These are always personal filings – not business - because there is usually no need to file a business proceeding. They are expensive and unnecessary because there aren’t usually any assets in the business to have to deal with/liquidate. Also, any purely business debts are dealt with simply via the company no longer operating, and the personal filing then covers them personally for personal debts.

(Regarding the house: in a bankruptcy, any home title is automatically transferred to the bankruptcy trustee who then is legally obligated to sell it. In a proposal, assets do not vest in the trustee, so one would keep their house but would have to pay to cover any portion of net equity that is theirs).

Case:

- former fast food restaurant owner; ran it for 8 years

- operated in Toronto’s PATH system (the underground shopping concourse)

- due to cumulative effects of COVID shutdowns and the subsequent rise of work from home, foot traffic was severely reduced and revenues tanked

- set up as a corporation (ltd co.); he was the sole shareholder and director

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Debt:

$80,000 unsecured; various big bank lenders; lines of credit and credit cards (all debts here are either purely personal or business but personally guaranteed); Bank A has the majority by $ owed

HST owing $72,000

- HST was not remitted in order to use that money for operating costs (a not-preferred but typical strategy to keep a struggling business afloat)

- HST is a ‘director liability’ debt (as with source deduction – AKA payroll tax) – so that directors cannot escape it by walking away from a corporation

Corporate tax owing $37,000

- NOTE: Corp tax is simply that: corporate only – there is no personal tie to it; this is in fact why you incorporate in the first place, although many may not have even realized it – to separate yourself legally from the company’s debts in such an eventuality (this is also why banks get personal guarantees – so corporation owners cannot escape those debts when closing company down)

CEBA loan $60,000

Total personal debt (from above): $152,000 (the $80,000 + $72,000 HST, which is a director liability debt and therefore follows one personally as director of a corporation)

Note: corporate tax and CEBA he is not personally liable for; CEBA loans were not made personally guaranteed by the government, therefore do not follow a corporation owner personally (for a sole proprietor they do as there is no legal separation)

No majority creditor; no single unsecured creditor can carry the proposal by themselves. This is important because in a consumer proposal you only need 51% of the dollars owed to approve the proposal. The rest are even if they if the dissent. Like an election. When there is a majority creditor, they sometimes throw their weight around and boss the vote. But when there isn’t one, there’s a better chance that an aggregate 51% will carry it with either little or no counteroffer.

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Assets:

Owns his home: joint with his son on mortgage and title

Value $875,000

Mortgages (2): 1^st $670,000; 2^nd $140,000 = $810,000 total

Mortgages payments per month: $5,282 (son pays half)

Approx. $10,700 net equity (his 50%)

No other assets: RRSPs were depleted over time to keep business going

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Income: now working on payroll at a food processing factory as a supervisor; $76,000 annual gross salary; his salary = $3,700/mo net

Wife works; makes $61,000 = $2,650/mo

Household income: $6,350

Surplus: $18,972 ($903 x 21 months) + equity $10,700 = $29,672 total realizable

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Many people who call us in this kind of situation first ask how much a business bankruptcy or a business proposal would cost. But we tell them there is no need to file a business proceeding. The vast bulk of the debt is personal only. The major purely corporate debts (CEBA loan and corporate tax) are dissolved when the corporation ceases to function. (You cannot formally close a corporation when there is debt owing, but the ceasing of operation achieves the same end. You are legally separate from your corporation, so filing a personal insolvency removes any trailing corporate debt form you personally – either personal guarantees on corporate debt or director liability debt such as HST and source/payroll deduction.) No need to file an expensive corporate matter.

1. Personal Bankruptcy surplus income* + equity = $29,672;

a. Either pay $903 x 21 months + let the house get sold by the trustee; or

b. Pay $1,413 x 21 months to cover both surplus income and home equity and therefore keep the house (house would be value again at time of discharge to se if any appreciation in value/equity)

2. CP $650 x 60 = $39,000 (30% gross payout); creditors can, of course, counteroffer

*when calculating a consumer proposal offering, we first calculate a hypothetical personal bankruptcy filing; that is because in a bankruptcy, the creditors would get X dollars in 21 months in this case – a surplus income bankruptcy length – and in a proposal you are offering a legal settlement to the creditors instead – but it is 60 months long. So you have to offer them more to get them to vote in favour of the proposal. There is a table of maximum net monthly income for a family of X members, above which a penalty must be paid in a bankruptcy filing.

OUR PLAN/STRATEGY/TACTICS/SOLUTION/RESUTRUCTURING:

We typically not only file a formal legal proceeding (bankruptcy or consumer proposal) to take care of the debt load, but also advise our clients on various other tactics by which they can put themselves in as optimum a position financially as is possible under the circumstances. That can mean any and all of the following:

- Banking; we always advise clients to change banks if they owe money to the bank they are doing their daily baking with, personal and/or business

o Canadian banks are afforded a right of offset under the Bank Act (see my recent article here Can Your Bank Take Your Money From You? ) and can seize funds if you either fail to pay them or file an insolvency proceeding; you need to first and foremost protect your money (and stop the bleeding/gain control)

- Operation: cease all operations of the company, including any banking or financial; this is to keep things tidy – you don’t want any more debt being incurred or funds flowing through any business accounts etc. (Note: you cannot close a corporation that owes debt, but you also do not need to – that is an administrative detail that you can address in the future; leaving it dormant causes no harm).

- Taxes: file a final / closing tax return for the corporation (to keep CRA happy); also file HST returns up to date, even if they are zero/nil returns; this is also to keep CRA happy with you (CRA love it when you are up to date, even if you owe them a ton of tax debt.

- Get a new HST # if continuing with a subsequent business; this allows both you and CRA to be able to separate what is what in future and not have any cross-contamination of tax or remittances. Makes for a clean break from Oldco to Newco. (in our case study, the gentleman is on payroll now, but most often skilled tradespeople continue operating under a new company.)

- If continuing on in another business, get set up for regular, quarterly HST remissions so as not to get too far behind in future. We always recommend you work with an accountant on this matter. Good business practice.

- Leave alone any purely corporate debts once the corporation ceases operation & once you file the consumer proposal. Corporate debts are corporate – not personal. Again – that is one of the reasons you incorporated in the first place.

- Disposition of business assets? Most small business either don’t have significant assets or they are tools of the trade, which are exempt to a large degree in a hypothetical bankruptcy calculation. If there are any business assets, you can liquidate them but you then want to pay your unsecured creditors proportional to what you owe them so they cannot invoke s. 95 of the BIA where it says you made a legal ‘preference’ of one creditor over another; proposals are meant to treat all creditors fairly.

So, do the above and file a Consumer Proposal. Offer $650 x 60 months = $39,000 total (includes the trustees fees, everything) on the $152,000 they owe. Save $113,000 in principal plus all future interest, avoid wage garnishees and CRA liens. And he gets to keep his house, probably to rebuild equity over time. Not a bad way to get a Fresh Start and also avoid filing bankruptcy.