Limitations on Tool of Trade Bankruptcy Exemption in Colorado for Small Business Owners

October 28, 2010

By: David M. Serafin

As a Denver bankruptcy lawyer, I’ve represented countless numbers of small business owners who file for a personal chapter 7 or chapter 13 in Colorado Bankruptcy Court intending to discharge both personal debt and personal guarantees for any business debt. With the exception of primary service based providers who own little or no assets (either individually or in the name of the business entity), many of my bankruptcy clients are the sole shareholder of a one person LLC or (sub-chapter) S Corporation which holds title to valuable equipment, inventory and/or goods.

Contrary to widespread belief, such business property is non-exempt even when the sole owner is only filing for personal bankruptcy. A careful review of the profit/loss statement, balance sheet and other financial statements of a business entity will indicate whether its assets exceed liabilities, or vice versa. The assets of a business with equity (i.e. assets which exceed liabilities) may be subject to the claims of the individual debtor’s bankruptcy trustee, with such assets subject to being sold to pay unsecured creditors.

In order to shield assets used in a business from the claims of the bankruptcy and unsecured creditors, particularly in a chapter 7, Colorado state law allows for the exemption of “[S]tock in trade, supplies, fixtures, maps, machines, tools, electronics, equipment, books, and business materials (up) to $20,000” and even enhanced protection for farmers or those in an agriculture related field for bankruptcies filed in 2010.

The caveat: the Tool of Trade exemption in Colorado can only be used by an individual and not a business entity, such as an LLC or S-Corporation. My guess as to why many small business owners title the assets in the name of the business entity is because they will enjoy the “limited liability” of owning a separate and distinct business entity (particularly where use of an asset may inherently lead to a high risk of injury, such as manufacturing equipment) in case a litigious creditor comes knocking.

But, absent holding inherently dangerous business equipment, an individual contemplating bankruptcy should consider initially purchasing and owning assets used for business personally to maximize the Colorado state homestead exemption.

I reiterate the term “initially purchasing” to emphasize that the bankruptcy and Colorado state fraudulent transfer laws may be triggered if an individual transfers title to assets to himself from the business entity in contemplation of bankruptcy, in which case the seizure powers of the trustee are re-triggered.

Please note that the adverse of effects of loss of the application of the Tool of Trade exemption in Colorado will likely be felt more in chapter 7 as an already financially struggling debtor will lose the non-exempt property to the bankruptcy trustee without having the ability to “buy back” such property from the bankruptcy estate. By contrast, if it’s foreseeable that the Tool of Trade exemption will be unavailable and particularly if the business assets outweigh the liabilities, I will recommend a chapter 13 filing in order to prevent involuntary liquidation of the business and as the equity in the business assets can be paid for over a 36 to 60 month payment plan.