For financial advisors, filing for bankruptcy has long been considered the ultimate taboo. After all, how can clients trust their advisor to manage their finances if he can't handle his own? But as the economic environment has pinned many advisors against a wall, for some, bankruptcy is their best chance at salvaging their business. At a time when the economic environment has flipped Americans' financial situations on their heads, it's important for financial planners to know how filing for bankruptcy would affect their ability—both legally and financially—to do their job.

Because of the LLC business structure, which most advisory firms employ, a bankruptcy will almost always be personal, not corporate. That said, there are myriad reasons an advisor may need to file for bankruptcy, the details of which will be an extremely important factor in dictating the repercussions of filing.

Many Americans were simply living beyond their means; that is, until 2008, when the market pushed their portfolios into the red, the price of their homes plummeted and the AUM fees they collected from clients dropped alongside the Dow. They're left with few options.

For others, bankruptcy is the price of breaking out on their own. Many veteran brokerage advisors crossed over to the independent side last year-and some, at a price. "The issue for a lot of guys who joined a large firm in the past five years is that they still owe money on recruiting bonuses that are structured as notes, so the contractual obligation is that you stay there long enough to pay off the note," says an advisor who left a wirehouse to start his own RIA last year. (He requested anonymity, as he negotiates the matter with his former firm, which accepted bailout funds from the government.) Bankruptcy is one option he is considering. Other advisors are considering bankruptcy due to illegal, fraudulent or non-fiduciary practices. For these planners, insolvency is only the beginning, the first domino to fall in a long line of tribulations.

But for financial planner David E. Martin, bankruptcy was his saving grace. When the market plunged in 2000, a few of his clients blamed him for their losses. "People felt we should've had them in safer parts of the market, and they began to sue," Martin explains. "The first one we remedied, the next one insurance covered, after that we got tangled up with a family that just relentlessly sued us. People thought I was just writing checks."

Martin never lost a single case in court. But pretty soon, he had incurred debt amounting tohundreds of thousands of dollars in legal fees. After speaking with several attorneys, and sitting silently in his office for two hours weighing his options, he decided to file for bankruptcy.

REACH OUT FOR HELP

No matter the reason for filing, the first step in the process is to contact bankruptcy counsel. Advisors can consult their current lawyer for recommendations, as he or she can help determine the type of counsel the advisor will need based on the complexity of the case, which can vary widely in cost.

Advisors should find counsel as soon as they begin to consider bankruptcy as an option. All too often, in an effort to keep their business afloat, small business owners deplete resources that could otherwise be protected in a bankruptcy case, says Tim Duggan, chairperson of the bankruptcy group at Stark & Stark, a Lawrenceville, N.J.-based law firm.

FIND YOUR WAY

The advisor's next step is to determine what type of bankruptcy is appropriate. An advisor must choose between Chapter 7, Chapter 11 and Chapter 13-each with their own requirements, and outcomes, Duggan explains. With Chapter 7 liquidation, a trustee is charged with selling the assets and paying the creditors, and the debts are discharged. Depending on what state the advisor is in, he may be able to retain his home and several other important assets. For instance, an IRA, a 401(k) plan, profit sharing and real property owned in a specific fashion cannot be liquidated to satisfy debt in a bankruptcy.

But not everyone can file for Chapter 7. Advisors must take a means test to qualify, which varies by state. In New York, the maximum median income for a family of four is $83,000. If his household has a higher income, the advisor must go through a complicated analysis to see if he can file for Chapter 7. In New Jersey and Connecticut, the maximum median income is $103,000.

The most common option is Chapter 13, which results in reorganization in which the advisor repays a portion of the debt over five years. Chapter 13 bankruptcies are cheaper than Chapter 11, in terms of the actual filing and attorney fees, and the case is much shorter.