Business Bankruptcy, Part 1

Your business is in trouble.

Customers/clients have dried up, and you can’t pay your bills (just ask some of my mortgage broker or Realtor clients). Or your rent payment and expenses went up, and you don’t have the cash flow to support their payment. Or your business partner took all the money in the bank account and left town without a forwarding address. What should you do?

Clients often come to see me with these and other problems. Most think that they want to file bankruptcy for their business. But in most cases, this may not be the best option. Here are the two main reasons why:

1. Corporations and LLCs generally cannot receive a discharge in bankruptcy. This means that after the case is over, creditors can resume their collection activities.
2. Better than filing bankruptcy for most corporations and LLCs who don’t owe tax debt is simply to liquidate assets, pay creditors pro rata, and close up shop. Creditors can’t collect from a business that has no assets and no customers.

So why do you read about business bankruptcies? Several reasons. Most business bankruptcies are Chapter 11 reorganizations, rather than Chapter 7 liquidations. In most Chapter 11 cases, a business can restructure debt payment, get out of bad leases, and wipe out much of their unsecured debt. For large businesses with significant assets and a big cash flow, financial problems can be fixed by shedding unprofitable leases and contracts and writing down debt.

The problem with Chapter 11 for small businesses? First, you may lose your ownership interest in the business, as well as money the business owes you. This is because of the “absolute priority rule,” which provides that creditors’ claims take priority over shareholders’ claims (although two recent cases cast doubt on whether this rule still applies after BAPCPA). Second, Chapter 11 cases can be fairly expensive, and if a business isn’t making money, and isn’t likely to make money, reorganization probably won’t help, and a Chapter 11 doesn’t make much sense.

When should you consider a Chapter 11 for your business? Generally speaking, when the business has been making good money, but runs into a temporary setback and restructuring can put it back on a firm financial footing. Under these circumstances, the costs and inconvenience of a Chapter 11 proceeding can be outweighed by the potential long-term benefits.

When does a Chapter 7 make sense for a business in severe financial trouble? Generally speaking, in three situations:

1. Where the corporation or LLC has assets and tax debt (in addition to other debt). Filing a Chapter 7 in these circumstances makes sure that the assets are liquidated and paid to the IRS, instead of other creditors. This can help to avoid or reduce personal liability for trust fund tax penalties under the “responsible person” tax doctrine.
2. Where there are assets and many creditors, and the owners prefer to let the bankruptcy trustee liquidate and distribute the assets to avoid squabbles about who gets what.
3. Where owners of a closed business are continually harassed by collectors seeking information about (non-existent) business assets.

In each of these cases, a corporate Chapter 7 may be of value. Note that the common situations, nos. 1 and 2, are where the corporation or LLC has assets. Odd as it sounds, filing a corporate Chapter 7 for a business with no assets usually doesn’t make sense.

The problem many of my clients have is not the corporation, which has no real assets and will be closing, but the guaranteed payments of businesses debt, or the failure to incorporate the business. What you should do in these circumstances will be the subject of Part 2 of this blog.