Filing for Chapter 7 bankruptcy can be a valuable option for corporations and limited liability companies (LLCs) that are going out of business. But this option isn’t used as frequently as one might think. Because these types of businesses don’t receive a bankruptcy discharge, filing for bankruptcy has limited value. And it can open the door to lawsuits that transfer debt liability from a company to an individual.

Read on to learn about how Chapter 7 bankruptcy can help corporations and LLCs, as well as pitfalls that you’ll want to avoid.

Corporations and LLCs: The Basics

A Chapter 7 bankruptcy filing works differently for businesses than it does for individuals—especially corporations and LLCs—primarily due to two factors:

• the unique “separate entity” status of these types of organizations
• an increased need to safeguard creditor interests when such businesses close, and
• the ability of creditors to take steps to shift liability from the company to an individual.

Forming a Corporation or LLC

A corporation or LLC is created by filing documents with the secretary of state and paying registration fees. Once established, the company operates as a separate legal entity. The business owns assets and is legally liable for paying its debts.

Because corporations and LLCs are separate entities, people don’t own them outright. Instead, individuals own stakes in the company rather than the company itself. For instance, an individual corporate shareholder will own shares of the corporation. An LLC member will hold an ownership interest that’s outlined in the LLC’s operating agreement. Each type of ownership interest entitles the holder to a portion of its value and profits.

Example. A shareholder or member who files an individual bankruptcy (not a business bankruptcy) doesn’t list the company itself as an asset in the bankruptcy paperwork. Instead, the filer will list the value of the corporate shares or the value of the LLC ownership interest as property owned. The bankruptcy trustee can sell only the filer’s interest in the company, not the entire business, unless the filer is the sole shareholder or member, of course. As an aside, few buyers are willing to purchase a partial interest in a small business.

These types of business structures work well for people who want to take part in business without risk to their personal wealth. The structure prevents business creditors from coming after an individual’s personal assets (although it doesn’t always work—more below).

(To learn more, see Business Formation: LLCs & Corporations.)

Closing a Corporation or LLC

When shutting the doors of a corporation or LLC, the corporate officer or the LLC’s managing member must sell off (liquidate) the company assets and distribute the funds to the creditors. Notice of proper closure must be filed with the secretary of state. Failing to follow these procedures could subject individuals holding an ownership interest to liability.

The requirements are intended to discourage the funneling of assets to insiders (stakeholders, business partners, and family members) because a creditor loses the ability to collect any remaining balance from the business once the business closes.

Chapter 7 for Corporations and LLCs: How It Works

Unlike Chapter 11 bankruptcy, Chapter 7 doesn’t have a mechanism that allows for the continued operation of a corporation or LLC. Filing this chapter will shut down the company.

The bankruptcy trustee will sell all of the corporation or LLC assets and distribute the proceeds among creditors according to the priority rules established in bankruptcy law (exemptions—the law that allows individuals to protect property in bankruptcy—aren’t available). The goal is an orderly business liquidation.

Not only will filing Chapter 7 close the business, but corporations and LLCs don’t receive a debt discharge. It isn’t needed. A creditor can’t collect from the company once it’s no longer operational. Nothing of value will be left to take.

Also, leaving the debt in place—rather than wiping it out—allows a creditor to pursue actions against individuals when appropriate. For instance, a creditor might seek payment under a personal guarantee (an agreement to be personally responsible for business debt), or pursue litigation under an alter ego or fraud theory (more below).

Chapter 7 for Corporations and LLCs: Advantages

So why would a corporation or LLC file a Chapter 7 case?

Winding down a business in bankruptcy allows for a higher level of transparency. It’s easier to prove that the closure took place in the manner required by law, which, in some cases, might prevent a disgruntled creditor from pursuing litigation (but not always). Here’s why.

A Chapter 7 liquidation can help alleviate a common creditor concern—that an officer or member might be diverting funds into private coffers rather than paying creditors because a business Chapter 7 is set up to sell the company’s assets and pay its obligations in a very public manner.

When effective, the officers and managing members get to step away from the closure and leave the hard work of selling off assets and paying creditors to the bankruptcy trustee. But, it doesn’t always go as smoothly as a filer would like.

Chapter 7 for Corporations and LLCs: Disadvantages

When you file for Chapter 7, you lose control of the company. The bankruptcy trustee takes over the business assets and determines whether it’s in the best interests of the creditors to sell the business as a whole or to sell off the assets.

If you’re liable for any of the business debt, this might cause a problem. After the bankruptcy, the amount of debt remaining will often be greater than if you took on the responsibility of selling the assets yourself. There are a few reasons this could happen.

• You might be able to get a better price for the business or assets (bankruptcy asset buyers are looking for—and expect—a deal).
• The sales proceeds will be reduced by the percentage the trustee will receive as payment.
• You won’t be able to negotiate and settle debt for an amount lower than what’s owed.

Any outstanding balance left after the trustee makes a payment will remain due and payable. As a result, you could be left with more liability than if you had negotiated with the creditors and sold the assets on your own.

Another disadvantage can prove to be even more expensive. Filing a case in bankruptcy court provides a disgruntled party—whether it be a creditor, business partner, or ex-spouse—with a forum to air any number of complaints about the handling of the business finances. And most disputes have the potential to shift debt liability from the business to an individual.

For instance, it doesn’t take much effort for a creditor to show up at the 341 meeting of creditors—the one hearing that all filers must attend—and provide the trustee with investigation-prompting information. When this happens, it’s common for a relatively short creditor’s meeting to be continued to allow for more thorough (and possibly uncomfortable) questioning.

It’s also fairly simple for a creditor to file an adversary proceeding—essentially a lawsuit—alleging any number of liability-shifting theories that would allow a creditor to collect from an individual’s personal assets. The possibility of opening the door to these types of litigation (discussed in more detail below) is often enough for most to avoid this chapter.

(For more information, see Adversary Proceedings in Bankruptcy.)

Personal Liability for Corporate or LLC Debts

Even though corporate entities and LLCs are responsible for their own debt payment, individuals can still find themselves liable for business obligations. Here are a few situations that can give rise to personal liability.

• Trust fund taxes. Responsible parties (often an officer or managing member) can be held liable for “trust fund taxes,” such as taxes withheld from an employee’s income.
• Alter ego claims. A creditor can go after the personal assets of an individual if it can prove that the corporation or LLC was a sham or an alter ego of the shareholder. Establishing this type of claim involves filing a lawsuit to pierce the corporate veil that shields a stakeholder’s private assets from the creditors of the business. A successful suit opens up more assets from which the creditor can collect.
• Other fraud claims. Most fraud involves an attempt to hide money from creditors. If proven, an individual would be required to make the harmed party whole (pay the money back), and possibly face criminal penalties, too.
• Personal guarantees. An individual can agree to be responsible for business debts by cosigning or personally guaranteeing a loan or by pledging personal assets as collateral—a common practice when a business lacks a profit history or valuable assets.

Putting the company through a Chapter 7 bankruptcy can help with these personal obligations, but only if the Chapter 7 trustee liquidates enough property to satisfy the debt. If a balance remains after the bankruptcy case, the creditor will be able to pursue the individual’s personal assets.

(To learn more, check out When You Might Be Personally Liable for LLC or Corporate Debt.)

How to Discharge (or Pay) Business Debt With an Individual Bankruptcy

If you’re liable for a personal guarantee, filing for bankruptcy can prove helpful. The most straightforward solution is often to file a consumer Chapter 7 bankruptcy. An individual can usually get rid of a personal guarantee for debts other than student loans—even if the business remains open—because most business debt can be discharged in an individual bankruptcy case.

Better yet, if most of your debt is related to the business (as opposed to consumer debt for personal needs), you might be able to qualify even if your income exceeds Chapter 7 limitations. Having more business debt than consumer debt allows you to avoid both Chapter 7 income requirements and the means test. So even if you have a healthy income, you still might be able to wipe out the personal guarantee in Chapter 7 bankruptcy.

If, however, your debt mix is such that you can’t avoid the means test and you don’t qualify for Chapter 7, you can always pay off the guarantee over five years in Chapter 13 bankruptcy. Also, although Chapter 7 bankruptcy won’t wipe out liability arising from most taxes and fraud, you can pay off these types of debts over time by filing for Chapter 13 bankruptcy.

(Find out more by reading The Bankruptcy Means Test: Are You Eligible for Chapter 7 Bankruptcy?)

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