Small Business Owners are Entitled to Exempt Reasonable Compensation from the Bankruptcy Estate

Rachel McGarry 

St. John's University School of Law 

American Bankruptcy Institute Law Review Staff

In In re Raza, a bankruptcy court in Virginia overruled a trustee’s objection to certain of the debtor’s claimed exemptions and held that a small business owner who received an Economic Injury Disaster Loan (“EIDL Loan”) with the U.S. Small Business Administration (“SBA”) was able to use those funds as reasonable earnings for himself, “which in turn may be exempted from the bankruptcy estate.”[i] The debtor in In re Raza was an owner of 4 Star Limousine, LLC (“4 Star”), a limited liability company that contracted with Uber to lease vehicles and “engage[] independent contractors to drive for Uber.”[ii] The debtor testified that he drove for 4 Star when the company was understaffed and “received a regular paycheck from 4 Star for [those] services.”[iii]

In December 2021, the debtor applied for an Economic Injury Disaster Loan (“EIDL”) for 4 Star with the Small Business Administration (“SBA”) and received $75,400.00.[iv]  When the funds from the EIDL were deposited into 4 Star’s bank account, the debtor transferred the full amount of the proceeds to his personal bank account.[v]

On December 24, 2021, the day after the debtor transferred the loan proceeds to his personal account, he filed a voluntary petition under Chapter 7 and failed to disclose the bank account on his Schedules of Assets and Liabilities.[vi]The Debtor initially claimed that the EIDL funds were not “property of his personal bankruptcy estate,” but later claimed that “$56,000.00 (75%) of the [EIDL] funds were exempt as ‘earnings,’” meaning those funds were unavailable for distribution to creditors.[vii] The trustee argued the debtor’s wage exemption claim was “an improper after-the fact characterization of the funds.”[viii] The trustee further argued that the EIDL funds “should be characterized as a distribution of profits” and therefore not exempt earnings.[ix]

The bankruptcy court held that the EIDL funds transferred to the debtor’s personal bank account qualified as earnings under Virginia Code § 34-29(a).[x] EIDL funds can be put toward operating expenses as well as payroll, and here, the debtor merely “transferred the funds to his personal bank account because he had not been paid.”[xi] The trustee argued that the exemption was “not properly claimed” because the debtor did not “claim the funds as earnings on his 2021 federal and state tax returns.”[xii] The court found that the EIDL funds not being included on the debtor’s tax returns was not enough to satisfy the trustee’s burden of proof.[xiii]

In In re Raza, the Virginia bankruptcy court relied upon the debtor’s failure to generate a profit during the relevant period to support the conclusion that the debtor’s transfer of EIDL funds was not a “transfer of profits.” For example, the debtor’s gross revenues dropped from 2019 to 2021 and the debtor was not paid in some time.[xiv] Moreover, the EIDL was not a distribution of profits “after payment of a reasonable salary to the debtor.”[xv]

The bankruptcy court in In re Raza overruled the trustee’s objection and found that “[s]mall business owners are entitled to pay themselves reasonable compensation as earnings for their efforts, which in turn may be exempted from the bankruptcy estate.”[xvi]  Consequentially, small business owners should not be afraid to pay themselves, even if they are going to need to file bankruptcy shortly thereafter.