Does Business Bankruptcy Affect Liability of Shareholders?

15 Jul Does Business Bankruptcy Affect Liability of Shareholders?

Occasionally I get inquiries from shareholders of small, closely held corporations, who ask about filing a Chapter 7 bankruptcy for the corporation. Usually these are folks who have either closed their business, or are in the process of winding up the corporation. (Those who want to reorganize in Chapter 11 are a different case altogether.) Very rarely do I recommend a Chapter 7 for a corporation, unless it is in conjunction with a filing for the shareholders individually.

Unlike individuals, corporations are not eligible for discharge (the court order that prevents creditors from trying to collect). Nor does a Chapter 7 for the corporation stop the creditors of the corporation trying to collect from the shareholders, if there is a basis for such liability. If the shareholders have personally guaranteed the debt, if the debt can be assessed against management (payroll taxes, for example) or there are grounds to pierce the corporate veil, a Chapter 7 for the corporation will not change that.

More importantly, a corporate Chapter 7 can actually compound problems for the shareholders. A Chapter 7 trustee’s job is to find a way to pay creditors. In addition to liquidating any assets of the corporation, the trustee is going to look for other sources of cash. For example, the trustee can stand in the shoes of creditors and sue the shareholders to pierce the corporate veil. If proper actions were not taken to maintain the corporation’s affairs separate from the shareholders, or if the corporation was undercapitalized (and very few closely held corporations are adequately capitalized), there is a risk that shareholders can be held liable for the entire debts of the corporation. The trustee can also sue to collect loans the corporation made to the shareholders, or to recover loan payments made to them in the year or more prior to bankruptcy. In short, a Chapter 7 may not help the shareholders, and may buy them a lawsuit, to boot.

A corporate Chapter 7 makes sense when the shareholders plan to file for bankruptcy protection as well, or are effectively judgment-proof.  In that case, the Chapter 7 for the corporation may be a convenient and cost-effective way of winding up the corporation.  In many cases, however, it’s not necessary.  If the shareholders file (whether Chapter 7 or Chapter 13), they will have the protection from creditors that they need.  Unless there are assets to be liquidated, it may be cheaper and easier to wind up the business, file final tax returns, and even dissolve the corporation.  Shareholders should focus on what kind of help they need, and whether Chapter 7 is really the best answer for the corporation.

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