When a business closes, it usually has a good-sized pile of debts—to landlords, suppliers, utilities, service providers, and possibly a bank or private lender. After you notify these creditors of your upcoming closure (which can limit your liability), you'll want to make plans to either pay these bills in full, settle them for less than full payment, or consider filing for bankruptcy. The fourth possible approach—ignoring your debts and hoping your creditors will ignore you—might be tempting, but don't go that route. It will probably result in your spending the next couple of years hounded by collection agencies, repo people, lawyers, and lawsuits.
Assuming you can't pay all your creditors in full, the question becomes: How little will they settle for? As you might guess, it depends on the type of creditor, the legal details of the debt, and the attitude of the creditor. For example, if your business is an LLC or corporation without any personally guaranteed debts, a creditor will know that it doesn't have the option of collecting from you personally, so it may be more willing to accept a small portion of what your business owes as complete payment. But if you owe a debt personally, or worse, a friend or relative cosigned for it, the creditor has much more leverage.
But no matter what the legal status of your debts, in our experience, if you can pay 30% to 70% cash on the barrelhead, it's worth trying to settle them. Many creditors, knowing that they will have a hard time collecting the debt once you are out of business, may agree to settle your debt for 50, 60, or 70 cents on the dollar—or even less if you hire a lawyer to negotiate for you.
Keep in mind that it won't help you much to settle one or two small debts for a reasonable amount while not being able to settle larger ones. So it might make sense to tell your creditors that your offers are contingent upon all of your creditors agreeing to settle their debts.
If you can't pay all (or most) of your debts, consider bankruptcy. Bankruptcy lets you wipe out debts you have no hope of paying—and if your business owes a pile of debts it can't pay, bankruptcy could offer the fresh start you need. To decide whether bankruptcy or a bankruptcy-like alternative, such as an assignment for the benefit of creditors, is your best course of action, see Nolo's article Going Out of Business: Liquidate Assets Yourself or File for Bankruptcy?
First, if you've pledged an asset that you own personally as collateral, and you want to keep it, you'll want to pay that debt first. You should then pay:
If there is money left over, then you can pay suppliers, credit card companies, lease deficiencies, and bills for random business expenses—advertising, travel and entertainment charges, dues and subscriptions, and repairs and maintenance. Let's look at how you might handle each type of creditor.
Make arrangements to return leased equipment such as copiers, machinery, and vehicles. If you return equipment before your lease term is up, you will no doubt be liable for either the remainder of the payments in the lease term or for an early return penalty. Try to negotiate a better deal while you've still got the equipment. For example, you might offer to return the forklift to the leasing company along with two months' additional payments in exchange for a complete release of further obligations.
Again, if lots of money is at stake and the lessor is not willing to cooperate, having a lawyer call, possibly with the suggestion that you may file for bankruptcy, can be a huge help. No lessor wants to cope with bankruptcy court and the fact that their property may deteriorate in the meantime.
Before you turn over any property to a secured creditor, try to negotiate with the creditor to release you from owing a deficiency (the difference between what you paid the creditor and what you owed on the lease or contract). If you aren't able to negotiate a release you and you owe the creditor money, the deficiency is now like any other unsecured debt (it's no longer secured because you returned the collateral).
After you notify your unsecured creditors that you are going out of business, they will start calling you, demanding to be paid. Often it's best simply to explain that you are preparing as fair a settlement offer as you can and will be in touch. Even if it takes a few weeks to be sure how much you owe and how much cash you have to divide among your creditors, it's worth the time to get it right. After you've collected outstanding A/R and sold off inventory and equipment, you should have at least a small amount of cash to use to discuss settlements.
If you have just a few creditors, you can explain your terms personally or by phone. Explain that your business doesn't have the money to pay the creditor in full but that you can offer a partial payment to settle the debt. If the creditors accept, great. Get each creditor to sign a release for the entire amount in exchange for your partial payment, and you're done. The release is critical—without it, you have no proof that the debt has been satisfied. Creditors could sue you or the business for the remainder of the debt, which would be expensive and time-consuming to defend, even if you end up not being liable for the debt.
If you have more than a few creditors, offering a settlement in writing is often your best course of action. In your letters, spell out what you can pay as settlement of the debt in full, that you're offering each creditor the same percentage, and that you'll need all creditors to agree to sign a settlement releasing the debt before you can make the payments.
If some creditors want to negotiate for substantially more or are threateningly uncooperative, it's time to involve a lawyer. This will immediately raise the seriousness of the negotiations, because the lawyer will be able to convincingly let the creditors know that you may file for bankruptcy if settlements aren't reached. Creditors know that the costs and delays inherent in bankruptcy would mean they will almost surely receive less than you are offering and they wouldn't get the money for many months, so most will accept your settlement.
A bankruptcy lawyer can also advise you on whether or not it makes sense to fully pay a creditor who refuses to accept less. Similarly, if a creditor makes a request for payment that you dispute, a business attorney can tell you what your next steps should be.
Debt forgiveness can be taxed as income. If creditors agree to settle your debts for less than the amount you owe, the IRS and state tax agencies may view this debt forgiveness as taxable income. (In other words, you don't have to pay the money, so it's like getting the same amount as income.) This could result in your actually having positive taxable income, rather than an operating loss, in the year you close. Owners of corporations and LLCs won't be personally liable to pay these taxes, but sole proprietors and partners should talk to a tax adviser to see whether this income can be applied to previous years' net operating losses or otherwise wiped out.
If, after making settlements with your creditors, you have any cash or assets left, you should set aside some money for potential future claims. Invariably, after you close up shop, a creditor will come out of the woodwork. Do your best to estimate any unpaid bills that might later surface or any potential lawsuits that could be brought against your business. Some experts recommend you set aside 1% of your annual revenue to provide for surprise creditors, but a reasonable amount depends on the hazards of your particular business. You can keep the money in your regular business bank account, a savings account, or, if the amount is significant, an escrow account. Some states actually require you to deposit the money into a trust account with the state controller or commissioner of revenue.
If your business is an LLC or corporation, keep the money set aside for two to five years, depending on your state's statute. This is important because, if a corporation or LLC distributes its assets to its owners after it dissolves and then a creditor appears within the two- to five-year period, the creditor can sue the business owners personally, to the extent of the assets distributed. If your business is a sole proprietorship or partnership, you may want to keep a contingency fund for three to ten years, depending on your state's statutes of limitation.
EXAMPLE: QuickClean Cleaners, Inc., closes its door after months of competing with three different dry cleaners within a three-block radius in downtown Stamford, Connecticut. After laying off employees, paying suppliers and creditors, and dissolving their corporation, the owners want to tie up loose ends. They know that customers take a while to make claims for lost or damaged apparel and that QuickClean usually has to pay out about $6,000 per year in claims not covered by insurance. Wanting closure but not wanting to risk later personal lawsuits, QuickClean sets aside $6,000 in a savings account, distributes the remaining assets to its three shareholders, and dissolves the corporation. If there is money left over in the account in two to five years, they can split the money among themselves.
Get help if you expect big creditors' claims. If you think significant claims could surface after you close your business, see a business lawyer or bankruptcy lawyer. Your state may impose specific requirements that you'll need to know about.