Bankruptcy basics: U.S. bankruptcy court.

With the economy on rocky footing, bankruptcies are on the rise. What docs this mean for your clients? They will be faced with the challenges that surface from slow collections, loss of business, impending foreclosure, layoffs or a combination of these and other factors. Whether you are an auditor, tax preparer or consultant, knowing the basics of bankruptcy can help you guide your client whether they are facing bankruptcy or suffering the ripple effects of others' filings through the maze of these harsh realities.

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For the 12-month period ending June 30, bankruptcies filed under chapters 7 and 11 exceeded 920,000 in the United States, a huge leap from the estimated 620,000 filings the year prior. If you drill down into those numbers you will see that the Chapter 11 filings almost doubled. In California there were in excess of 130,000 bankruptcies filed under chapters 7 and 11 for the year ending June 30, an increase of more than 150 percent over the prior year. This docs not bode well for your clients, their customers or their vendors.

Bankruptcy Basics

A Chapter 7 bankruptcy is a method of liquidation and redistribution of assets and a discharge of debt. Conversely, Chapter I 1 typically means that the debtor--usually a company plans to continue operating and restructure its debt. Often in a Chapter 11 there will be a Plan of Reorganization filed that provides the specifics of how the claims in the estate will be treated and the plan implemented, among other things.

A bankruptcy can be voluntarily filed by the debtor or involuntarily filed by creditors that satisfy certain requirements. The period before the bankruptcy is filed is the pre-petition period, and the period from the date the bankruptcy was filed through the discharge is the post-petition period. The entity that is created through the filing of Chapter 7 or Chapter 1 1 by an individual is a new taxpaying entity; separate and apart from the debtor. There are special tax rules that apply to both the debtor (pre- and post-petition) and to the estate in individual, corporate and partnership bankruptcy cases. Tax practitioners should be well-versed in those particulars if they are retained to provide tax services in a bankruptcy setting. (Internal Revenue Code sees. 1398 and 1399).

It's important, too, to know the key players as you navigate these waters.

The debtor is the bankrupt person or entity, and the creditors are those to whom the debtor owes money; Depending on a number of factors, the debtor in Chapter 11 may act as a debtor-in-possession and continue to run the business after the bankruptcy is filed, or a trustee may be appointed to oversee the entity through the bankruptcy proceedings. The trustee steps into the shoes of the debtor and is responsible for managing the business and operations of the debtor. Others parties you may encounter are attorneys, creditors, accountants to the trustee and a creditors' committee. A bankruptcy judge will be assigned to the case and the United States Trustee's Office will be involved to monitor the case and provide oversight.

Among the initial documents that surface are the voluntary or involuntary bankruptcy petition; statement of financial affairs; and the schedules of assets and liabilities, current income and expenditures, plus unexpired leases and executory contracts (contracts between the debtor and another party in which both sides have to perform--i.e. lease of real estate). These documents provide the date of the bankruptcy, the assets and liabilities of the company the key background and operational information, and a list of creditors.

If you or your client is a creditor, a proof of claim should be filed with the estate so that the claim is recognized and can be reviewed by the trustee or debtor-in-possession, who will then either approve or dispute it and classify it according to type of claim. Creditors often band together and form creditors committees that can be represented by separate counsel and paid out of the bankruptcy estate.

The Options

Bankruptcy can be used as a tool for a debtor to take a step back and regroup as it struggles with financial obstacles. In that regard, the bankruptcy code affords them what is known as the "automatic stay," which basically halts any litigation against the debtor. This means there can be no foreclosure, garnishment, repossession or other lawsuits brought or enforced against the debtor or property of the debtor unless the bankruptcy judge grants relief from the automatic stay.

On the other hand, the court does not minimize a secured creditor's rights and provides them with adequate protection meaning their interest in property must be maintained and protected by the debtor-in-possession or trustee.

Avoidance actions are another tool at the disposal of the debtor-in-possession or trustee. There are three types of avoidance actions: preferences, fraudulent transfers and post-petition transfers. Each provides a method by which money or other property may be brought back into the estate.

Preferences allow the trustee or debtor-in-possession to avoid transfers that occurred on or within 90 days of the filing of the petition, and up to one year if the transfer was to an insider. This way no one party has been preferentially treated.

Fraudulent transfers allow a similar avoidance of transfers on or within two years of the filing of the petition under federal law for longer under state fraudulent transfer laws) if either:

1) There was intent to hinder, delay or defraud creditors; or

2) The debtor received less than reasonably equivalent value and was insolvent.

Post-petition transfers are transfers of property of the estate made after the petition has been filed. They, too, can be avoided.

The specific rules surrounding avoidance actions are complex and more detailed than what was briefly explained here, but you can consult the bankruptcy code sees. 547, 548 and 549 for more details. Keep in mind that although avoidance actions may benefit your client if they result in additional funds in the estate, your client may also be on the receiving end of an avoidance action lawsuit for having received funds determined by the trustee or debtor-in-possession to be recoverable by the estate.

Making the Call

One of the biggest decisions to make after bankruptcy is filed is whether to assume or reject an unexpired lease or executory contract. Of course, if the debtor defaulted on the lease or contract, nothing can be assumed unless the default is cured, there is assurance of future performance, and compensation is paid to the party, to the lease or contract.

These decisions are critical when considering the business' future operations and restructuring options, and there are time limits under which assumption or rejection must occur. Therefore, if your client happens to be the landlord of the debtor, these are issues that need to be addressed soon after the bankruptcy is filed. You may be in a good position to provide assistance by calculating the obligations under the lease as of the date of the bankruptcy filing or assisting with the monitoring of future rents.

Bankruptcy can be a long process or streamlined to conclude quickly--especially if there was significant pre-bankruptcy planning.

If it is determined that your client is a creditor in the estate, the claim will be assigned a priority. Secured claims (which means there is a lien on particular property of the debtor up to the value of the collateral or it is subject to a set-off) are given the highest priority and are paid first. Unsecured claims (those that are not secured by any collateral) receive the lowest priority and are typically paid last and often not in the full amount due to the lack of funds available for distribution. There are several layers of priorities between claims, but the creditors composing each priority of a claim is paid pro rata with the other creditors in that group as a means of providing equitable treatment.

Bankruptcy is a complicated matter and may require knowledge beyond your expertise. Depending on the situation, you may need to advise your client to retain bankruptcy counsel to make sure their rights are protected. But it is you, as their trusted adviser, who should be there from the start to offer basic advice and guidance.

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Bankruptcy Conference

The CalCPA Education Foundation is offering a day-long Bankruptcy Conference Nov. 6 covering, among other things: how to navigate through bankruptcy, taxation in bankruptcy and bankruptcy fraud.

Learn more and register at

www.calcpa.org/BC, or join us by webcast at www.calcpa.org/BCwebcast.

Maryellen K. Sebold, CPA/CFF, CIRA is a managing director with Durkin Forensic, Inc. in Los Angeles. You can reach her at [e-mail].