When business is poor and creditors are banging loudly at the door, it may be time to consider a Chapter 7 business bankruptcy. Unlike Chapter 13 which is only available for individuals, a business may file under Chapter 7 which holds some distinct advantages and disadvantages for the business and its shareholders.
For many failing businesses, the main advantage to a Chapter 7 bankruptcy is the automatic stay. This protection will temporarily halt any collection process or legal action, including a repossession, lawsuit, eviction, or foreclosure. The bankruptcy case stops a “money grab” at business assets and allows the company to liquidate assets and pay creditors in an orderly and often beneficial manner.
Because the automatic stay stops any lawsuits, company officers are no longer required to participate in the suit, including appearing at hearings or depositions. Should a creditor desire to continue a lawsuit, it must first seek permission from the bankruptcy court. Continued litigation is often restricted to the forum of the bankruptcy court.
The main reason to file a Chapter 7 bankruptcy for a business is to allow a Chapter 7 bankruptcy trustee to take control over the company and formally dissolve it. When the company files Chapter 7 bankruptcy, the officers and shareholders are no longer in control over the business, and there is no longer an opportunity to continue the business or sell it in whole or part to someone else. The responsibility of “winding up” the company falls squarely on the trustee’s shoulders. This can relieve shareholders from personal liability during the liquidation of company assets.
Being relieved of command does not release responsibility or liability. Officers and shareholders must cooperate with the bankruptcy trustee and provide records and information, along with access to company assets. The trustees may be able to recover monies from creditors who were paid shortly before the bankruptcy case and received more than their fair share. Collecting and redistributing money that was paid to creditors before bankruptcy can sometimes be beneficial to the shareholders. For instance, when a preference payment is avoided and the proceeds are used to pay an unpaid “trust fund tax debt.”
The trustee will (generally) stop business activities, liquidate assets, and pay creditors according to the priority set out in the Bankruptcy Code. For instance, tax debts and employee wages are paid ahead of unsecured creditors. Before entering a business bankruptcy, it is important to recognize that the trustee will usually sell business assets for less than fair market value (usually at auction), so it may be advantageous to sell business assets at a fair price before filing bankruptcy. The trustee can then distribute the cash proceeds from the sale during the bankruptcy case.
A Chapter 7 discharge is only available to individual debtors, not to partnerships or corporations. See 11 USC § 727(a)(1). Business debts in Chapter 7 are not discharged, so the winding up and dissolution of the company in bankruptcy does nothing to relieve the potential liability of owners. Any personal guarantee of a business debt will survive the Chapter 7 business bankruptcy. Likewise, the bankruptcy does not release the liability of an individual identified by the IRS as a “responsible person” (someone with the duty to collect, accounting for, or pay over trust fund taxes).
The bankruptcy trustee may seek to recover money from an officer or shareholder if there was mismanagement or failure to follow the corporate rules. This is especially the case for small business owners who may have co-mingled business and personal assets, or where personal expenses were paid with company funds. Consequently, a considered evaluation of the business and ownership liability must be performed before the decision is made to file bankruptcy.