The Small Business Reorganization Act of 2019 (“SBRA”) provides a new remedy for small businesses looking to use bankruptcy for a fresh start. The SBRA’s streamlined process makes it possible for small business debtors to reorganize and rehabilitate their financial affairs more efficiently.

But, to qualify for reorganization under the SBRA, there are requirements that must be met. Pursuant to Section 1182(1)(A), a debtor interested in restructuring under the act must be “a person engaged in commercial or business activities.” Three elements arise out of that requirement: (i) be a “person,” (ii) “engaged in,” (iii) “commercial or business activities.” Understanding what “person” means is simple enough, since it is defined at Section 101(41) of the Code. The Bankruptcy Code provides no definition for the other elements. As a result, debtors and their attorneys must turn to case law to interpret what those last two elements mean. One such case, In re Rickerson, was decided at the close of 2021 by the Bankruptcy Court for the Western District of Pennsylvania.

Before turning to the facts of that case, it is helpful to note that most courts are adopting the viewpoint that the burden of establishing the SBRA’s eligibility requirements falls on the debtor rather than the party opposing reorganization. The Rickerson Court itself notes this fact, citing In re Blue from the Bankruptcy Court of the Middle District of North Carolina as support for its statement that “[t]he large majority of” cases that have looked to the eligibility requirements of Subchapter V have placed that burden on the debtor. So, debtors should keep in mind that it is usually their burden to prove that they meet these requirements, which makes understanding the case law interpreting those elements particularly important.

In Rickerson, the debtor was looking to restructure debts held by three different business entities. Each of those entities played a role in the debtor’s medical practice. One was a corporation that existed to fund the debtor’s medical practice. Another was the company that the debtor used to conduct her actual medical practice. The third and final company was a real estate partnership that owned the real estate where the medical practice operated. The debtor was not particularly involved in any of those businesses at the time of filing for bankruptcy. In fact, none of the three companies were conducting business nor holding any assets at the time of the debtor’s filing. Instead, the debtor was working as a W-2 employee with a separate business. That raised a question as to whether the debtor was “engaged in” business activity by merely holding onto those three companies as past business activities.

Turning to that question, the court in Rickerson determined that eligibility under the SBRA requires the debtor to be “presently engaged” in business. In other words, the court determined that there is a “temporal” aspect of the bankruptcy that must be considered when assessing whether a debtor is “engaged in” business. Thus, bankruptcy courts, debtors, and attorneys are tasked with determining whether “engaged in” requires the debtor to be participating in the business at the time she files for bankruptcy or whether a debtor only needs to have engaged in such business at some point in the past. Courts vary on that issue, as the Bankruptcy Court for the District of South Carolina previously came to the opposite conclusion in In re Wright.

In Rickerson, the court adopted the former viewpoint, finding that the natural reading of the statute requires “contemporaneity.” Drawing an example from the Southern District of West Virginia, the court reasoned that the phrase “[s]he is a member of an organization engaged in philanthropy” defines the organization spoken of to be presently involved in philanthropy. This approach seems logical and might be what one would expect the phrase “engaged in” to mean in an everyday conversation.

So, Rickerson shows that merely maintaining a business as an empty shell could cause a debtor to fall short of meeting the “engaged-in” requirement for Subchapter V filings. But, that leaves the question of exactly when a business becomes an empty shell. For example, a business that is “winding down” is not an empty shell, but it is also not quite engaged in the full breadth of its usual business. While the court in Rickerson found that it did not need to decide that issue, it did hint that it is “perhaps not unreasonable” to consider a business that is in a “winding down mode” to be “engaged in commercial or business activities.” This seems to suggest that the threshold for falling outside of the “engaged in” requirement is somewhere between the “winding down” phase and “empty shell” phase.

The second issue that the Rickerson opinion provides guidance on is when a debtor’s activities can be categorized as “commercial or business activities.” The SBRA requires that 50% of the debtor’s “aggregate noncontingent liquidated secured and unsecured debts” arise from “commercial or business activities of the debtor.” So, it is important for a debtor to understand whether her debts will be considered “commercial or business” debts that count towards that 50% threshold. The court in Rickerson assessed that second question by looking at three debts held by the debtor: (i) debt from a loan to acquire business property and launch a medical practice; (ii) an IRS debt; and (iii) debt owed to the Pennsylvania Department of Revenue.

As noted above, it is generally a debtor’s burden to prove that she meets the requirements of the SBRA —including this “commercial or business activities” requirement. Failure to meet that burden can be fatal to a debtor’s election. As a prime example, the court in Rickerson refused to analyze whether the debt to the Pennsylvania Department of Revenue came from commercial or business activities, simply because the debtor failed to produce evidence about that debt at the evidentiary hearing. The court did provide some insight about the other two debts.

First, the court assessed the loan for acquiring business property. The debtor’s debt for acquiring business property and launching a medical practice was disclosed as $352,578.77. However, the court in Rickerson noted that $11,678.42 was for real estate taxes on the debtor’s residence, which the lender had paid in advance. Those real estate taxes were excluded from the permitted debt, leaving a total of $340,900.53 in commercial or business activities for the debtor’s first debt (the loan to acquire business property and launch her medical practice). This outcome shows that courts may take a close look at the components of debts in question to determine whether they fall under the definition of commercial or business debts. In situations where the total amount of a debt includes consumer debt, it is almost certain that the consumer debt will not be lumped in with debts from valid “commercial or business activities.”

The third debt was owed to the IRS, and the parties hotly contested whether this was a business debt. Working under the assumption that a personal income tax obligation could be considered a business debt for purposes of eligibility under the SBRA, the court determined that all the IRS debt that accrued after the debtor’s medical practice had ceased operations could not be considered part of the Subchapter V debt. The reasoning was simple enough: debt that was incurred after the practice was sold “could not possibly be considered as arising from commercial or business activities since those activities had ceased.”

For the debt that accrued before the debtor’s medical practice ceased operations, the court was required to delve into the record to determine what kind of employee the debtor was during the years which the debt accrued. Put simply, the court needed to determine whether the debtor was a W-2 employee or an independent contractor during the relevant years. If the debtor was an independent contractor when the IRS debt accrued, then the debt would have arisen out of a “personal responsibility” to pay the taxes, which would not fall under the umbrella of business or commercial activities.

In contrast, a W-2 employee might argue that her employer should have made tax withholdings from the employee’s pay. Perhaps a business’s failure to make those withholdings for a W-2 employee could provide a persuasive argument that an IRS debt could be a business or commercial debts. But, the court in Rickerson hinted that those tax obligations are still unlikely to be considered business or commercial debts when the debtor owns the business that failed to make the necessary withholdings for its W-2 employee. Again, the court concluded that the debtor simply failed to meet her burden of proof that any of the IRS tax debt should be considered business debt. While there is a distinction between an independent contractor and W-2 employee, it is unclear whether that distinction creates a viable argument that a tax debt—for either type of employee—should be considered a commercial or business debt rather than a personal debt. At the very least, the opinion in Rickerson makes it clear that an independent contractor’s debt is a personal responsibility that is highly unlikely to be considered a business or commercial debt.

In sum, the Small Business Reorganization Act of 2019 provides a powerful tool for small businesses looking to use bankruptcy for a fresh start. But, debtors pursuing that avenue should be aware that proceeding on that path requires a debtor to use diligence in proving that she meets the SBRA’s requirements. Rickerson is one of many cases that provides insight on how courts have interpreted those requirements so far. The opinion that serves as a pertinent reminder of the various mistakes — such as failing to meet evidentiary burdens — that debtors and their attorneys should keep in mind when pursuing this option.

March 2, 2022/by Bankruptcy