Chapter 7 Bankruptcy for LLCs and Corporations

Filing for Chapter 7 bankruptcy is an option for corporations and limited liability companies (LLCs) going out of business. But business Chapter 7 bankruptcy cases aren't filed as frequently as you might think. Why? Because LLCs and corporations don't receive a debt discharge eliminating debt. Also, a Chapter 7 filing can open the door to lawsuits transferring debt liability from the company to an individual interest holder.

If you're considering bankrupting a corporation or LLC in Chapter 7, keep reading to learn about the benefits and pitfalls of closing companies using Chapter 7. If you'd like a refresher on how LLCs and corporations are formed and closed, skip to "Understanding Formation and Closure Requirements of LLCs and Corporations" at the end of the article.

Can an LLC Declare Bankruptcy? How About a Corporation?

Yes, an LLC can declare bankruptcy, and so can a traditional corporation. However, the bankruptcy chapter filed will determine whether the LLC or corporation remains open and operational after the bankruptcy filing.

Filing a Chapter 7 bankruptcy will close the LLC or corporation. To keep a company open and operational, Chapter 11 or Chapter 11, Subchapter V are better options.

What Happens to Corporations and LLCs in Chapter 7 Bankruptcy: The Basics

A Chapter 7 bankruptcy works differently for LLCs and corporations than individuals. Here, you'll find a brief explanation of what to expect. A more thorough discussion of important issues follows.

Company Property Gets Sold

The primary purpose of Chapter 7 is to allow the Chapter 7 trustee assigned to the case to inventory and sell the business property and use the proceeds to pay creditors. Allowing a neutral third party to conduct this aspect of the business closure has two primary benefits: It takes the burden off stakeholders and assures creditors of the propriety of the asset sale.

What's the result of the sale of the company assets? Selling equipment, inventory, products, and supplies ultimately closes the company.

Company Debt Remains

The corporation or LLC will not receive a debt discharge in Chapter 7, leaving the company responsible for its obligations. The debt discharge isn't necessary because creditors can't collect from a closed and defunct company.

Leaving liability in place also allows creditors to collect in several instances:

• Creditors can collect from anyone who signed a personal guarantee agreeing to pay a business debt if the company defaulted.
• A creditor can collect from a stakeholder after proving in a pierce-the-corporate-veil lawsuit that the company is the stakeholder's alter ego.
• Creditors can collect against a new business if a court declares the new business is essentially an extension of the closed business. This situation can occur when a company closes to avoid paying its obligations and reopens under a new name.

Learn more about when you're personally liable for business debts.

Increased Liability for Corporations and LLCs in Chapter 7 Bankruptcy

One of the most significant downsides of putting an LLC or corporation in Chapter 7 bankruptcy is that it provides an easy and instant forum for a lawsuit. All a disgruntled creditor must do is file a motion or bankruptcy lawsuit called an "adversary proceeding" to ask for relief.

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. Chapter 7 is a quick bankruptcy chapter designed for people and companies without an income source to pay debt. The primary function of Chapter 7 is to liquidate assets and pay creditors, which is why filing this chapter will shut down the company.

To achieve an orderly business liquidation, 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.

As discussed briefly above, 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. After all assets are sold for the benefit of creditors, as required in a business closure, 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.

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. Here's why.

A Chapter 7 liquidation can help alleviate a common creditor concern—an officer or member might divert funds into private coffers rather than paying creditors. A business Chapter 7 publicly sells the company's assets and pays its obligations.

When it works, 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.

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.

Problems for Personal Guarantee Signers

If you're liable for any business debt, the lack of control might cause a problem if the sales proceeds from the business assets aren't sufficient to pay a debt you guaranteed or that you're responsible for paying by statute, like certain taxes.

After the bankruptcy, the remaining debt will often be more significant than if you sold the assets yourself for several reasons:

• You might be able to get a better price for the business or assets because bankruptcy asset buyers are looking for and expect a deal.
• The sales proceeds will be reduced by the percentage the trustee receives as payment.
• You give up the ability to negotiate and settle debt for less than the balance owed.

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

Litigation Problems for Stakeholders

Another common disadvantage is often even more expensive. Filing a case in bankruptcy court provides a disgruntled party—whether a creditor, business partner, or ex-spouse—with a forum to air any complaints about handling the business finances.

This problem concerns stakeholders because most disputes can potentially shift debt liability from the business to an individual. For instance, it doesn't take much effort for a creditor to attend the 341 meeting of creditors—the one hearing all filers must attend—and provide the trustee with investigation-prompting information.

When this happens, it's common for the trustee to continue a relatively short creditor's meeting to another day for more thorough and often uncomfortable trustee questioning. The purpose of the continued meeting is for the trustee to use the new information to find assets for creditors, and yes, they'll be on the same side.

It's also relatively simple for a creditor to file an adversary proceeding—essentially a lawsuit—alleging 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 is often enough for most to avoid Chapter 7 bankruptcy (more below).

Personal Liability for Corporate or LLC Debts

Even though corporate entities and LLCs are responsible for 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 an individual's personal assets 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 business's creditors. 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.
• Personal guarantees. An individual can agree to be responsible for business debts by cosigning or personally guaranteeing a loan or 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 can 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 By Filing Bankruptcy Yourself

When a business is failing or closed, often the most straightforward solution to debt problems isn't bankrupting the company. It's frequently more efficient for the owner or stakeholder to file a consumer Chapter 7 bankruptcy personally.

An individual can usually get rid of many personal debts, such as credit card balances, medical bills, and personal loans, but also erase a personal guarantee for business debts. This is the case even if the business remains open because filers can discharge most business debt in an individual bankruptcy case.

Learn about the debts erased in Chapter 7 bankruptcy.

Relaxed Chapter 7 Qualification Requirements

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

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

Chapter 13 Can Help Filers Keep Property

Sometimes, business owners find Chapter 13 offers better debt relief options. For instance, if you don't qualify for Chapter 7, you can restructure debt over five years using a Chapter 13 plan.

Chapter 13 will also let you keep the property you'd lose in Chapter 7. And, although Chapter 7 bankruptcy won't wipe most support arrearages, tax, and fraud debt, you can pay off these types of debts over time without worrying about creditors knocking at the door.

Understanding Formation and Closure Requirements of LLCs and Corporations

You likely understand the ins and outs of creating and closing an LLC or corporation. However, we include them here if you'd like a refresher.

Forming a Corporation or LLC

Chapter 7 can be risky for a corporation or LLC because it's a separate legal entity. Once created by filing documents with the secretary of state and paying registration fees, the newly formed 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 outlined in the LLC's operating agreement. Each ownership interest entitles the holder to a portion of its value and profits.

These types of business structures work well for people who want to participate 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).

Example. A shareholder or member who files an individual bankruptcy (not a business bankruptcy) won't list the company 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.

As an aside, few bankruptcy asset buyers are willing to purchase a partial interest in a small business. This fact can come into play when filing personal bankruptcy and calculating the risk of the Chapter 7 trustee selling the filer's business ownership interest.

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 or "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 discourage the funneling of assets to insiders (stakeholders, business partners, and family members) because, in most cases—other than those discussed above—a creditor loses the ability to collect any remaining balance from the business once the business closes.

Need More Bankruptcy Help?

Did you know Nolo has made the law accessible for over fifty years? It's true, and we want to ensure you find what you need. Below, you'll find more articles explaining how bankruptcy works. And don't forget that our bankruptcy homepage is the best place to start if you have other questions!

We wholeheartedly encourage research and learning, but online articles can't address all bankruptcy issues or the facts of your case. The best way to protect your assets in bankruptcy is by hiring a local bankruptcy lawyer.