Question

Henry Duller has invested $500,000 in Northeast Development Company. The firm has recently declared bankruptcy and has $800,000 in unpaid debts. Explain the nature of payment, if any, by Mr. Duller in each of the following situations. Northeast Development Company is a sole proprietorship owned by Mr. Duller. Northeast Development Company is an 80-20 general partnership of Mr. Duller and Christina White. Northeast Development Company is a limited partnership, with Mr. Duller serving as the general partner. Northeast Development Company is a limited partnership, with Ms. White serving as the general partner. Northeast Development Company is a corporation.

a. Northeast Development Company is a sole proprietorship owned by Mr. Duller.

b. Northeast Development Company is an 80-20 general partnership of Mr. Duller and Christina White.

c. Northeast Development Company is a limited partnership, with Mr. Duller serving as the general partner.

d. Northeast Development Company is a limited partnership, with Ms. White serving as the general partner.

e. Northeast Development Company is a corporation.

Answer 1

a. Northeast Development Company is a sole proprietorship owned by Mr. Duller.

A sole proprietorship is not a separate entity from its owner. In the case of a bankruptcy, the sole proprietor is personally liable for any business debt or liability. Therefore, debt payment can be done using proprietor’s personal assets, including any homes, cars personal bank accounts and any other assets. Even owner’s personal liability insurance cannot protect the owner from debt claims. In case of Bankruptcy, the sole proprietor has two options:

• Liquidation Bankruptcy – the Business assets are distributed according to the bankruptcy court and payoff the debts. If business assets are less than the value required for paying off the debts then proprietor’s personal assets even family home can be used for repayment. Once the assets are distributed, the sole proprietor receives a discharge which releases the owner from debt obligations.
• Reorganization bankruptcy – usually filed by consumers but can be used for sole proprietorships. A repayment plan is filed with the bankruptcy court that details how the debtor plans to repay the debts. The repayment amount depends on the owner's income, property value as well as the overall debt. If the owner's personal assets are commingled with the business assets, the owner may be able to retain certain assets such as a family home.

Therefore, Mr. Duller is fully responsible for the repayment of the proprietorship firm’s debts even with his personal assets.

b. Northeast Development Company is an 80-20 general partnership of Mr. Duller and Christina White.

In a general partnership, all partners are general partners and they are personally liable for the business debts of the partnership. If the partnership fails to repay its business debts, the debt can be recovered from the personal assets of its partners. However, as opposed to a personal bankruptcy, partnerships cannot generally receive a discharge. All business assets of the partnership are liquidated and dispersed.

Therefore, Mr. Duller and Ms. White are both responsible for the partnership firm’s debts with their personal assets. The repayment of debts liable will be equal between both partners unless otherwise mentioned.

c. Northeast Development Company is a limited partnership, with Mr. Duller serving as the general partner.

A limited partnership requires at least one general partner with multiple limited partners. The general partner is totally responsible for the business debts of the partnership even personally. However, there is no personal liability for limited partners in a limited partnership firm.

Therefore, Mr. Duller will be liable for the partnership debts personally but Ms. White is not liable more than the partner’s initial contribution.

d. Northeast Development Company is a limited partnership, with Ms. White serving as the general partner.

A limited partnership requires at least one general partner with multiple limited partners. The general partner is totally responsible for the business debts of the partnership even personally. However, there is no personal liability for limited partners in a limited partnership firm.

Therefore, Ms. White will be liable for the partnership debts personally but Mr. Duller is not liable more than the partner’s initial contribution.

e. Northeast Development Company is a corporation.

All the company’s assets are liquidated and the money is used to pay off the debts. But not all debt is created equal. Not surprisingly, the investors or creditors who have taken the least risk are paid first. For example, secured creditors are even more risk-averse than regular bondholders as they accept very low interest rates in exchange for the added safety of corporate assets being pledged against corporate obligations. Therefore, when a company does go under bankruptcy secured creditors are paid back the first. However, Equity shareholders have the full potential of seeing their share of the company’s retained income which would be reflected in the stock’s price. As such, equity shareholders may not be fully compensated for the value of their shares, in the light of risk-return trade off. This principle is referred to as absolute priority.