When you're going out of business but you don't have enough money to pay the business's debts, you need some portion of your debts forgiven or discharged (as in Chapter 7 bankruptcy). As an alternative to filing bankruptcy, many sole proprietors, as well as owners of small insolvent corporations, LLCs, and partnerships, liquidate their own business assets and negotiate their own debt settlements. This is often called an "out-of-court work out."
The idea is simple: You or your lawyer calls each of your creditors and asks them to release you from the debt, in exchange for some fraction of the full amount you owe. Why should creditors do this? Because it's often a better choice than suing you and trying to chase down your remaining assets while hoping you don't file for bankruptcy, which creditors know will leave little or nothing for them after costs and fees are paid.
EXAMPLE: When Darla closes down BookNook LLC, she owes three publishers a total of $80,000, $4,000 to her landlord on the month-to-month lease that she personally guaranteed, and $1,000 to utility companies. She returns as much book inventory as possible to the publishers, lowering the amount she owes them to $40,000, and notifies them in writing that she's going out of business. She then sells off her used book inventory as well as her bookshelves, cash registers, and computers (mostly to a competitor, the rest on craigslist), leaving her with $25,000 in cash. She gives notice and pays her landlord the $4,000 past due—this is a high priority because she personally guaranteed the lease—and writes checks to the utilities. Darla then writes to each of the publishers offering a final payment of 50 cents on the dollar ($20,000 to satisfy her debts of $40,000). She makes the offer contingent upon the publishers' signing a written release that releases BookNook, Darla, and her spouse from any liability for the debts. The publishers, knowing that BookNook is an LLC and that Darla can either walk away from the business or file a Chapter 7 business bankruptcy, much prefer getting half their money immediately, so they take the deal.
Obviously, to make a out-of-court work out work, you need to have enough business cash and assets that you can make at least partial payments on your debts. If you are flat broke, your creditors will have no incentive to negotiate with you.
If your business is a corporation or LLC and you haven't signed any personal guarantees or become personally liable for any debts (such as unpaid payroll taxes), you don't actually have to wait around for creditors to sign releases. You can simply close the business, sell its assets, and pay your creditors on a pro rata basis until the business's cash is exhausted. You won't be personally liable for the balance of the debts your corporation or LLC can't pay.
The downside of this approach is that by not getting signed releases, you open yourself up to being hounded for years by collection agencies and possibly even being sued. If you are sued, you'll at least have to file a response in court pointing out that you aren't personally liable for the debt, and you may have to hire a lawyer or appear in court. Worse, a creditor might even argue that your corporation or LLC was just a sham to help you defraud creditors and that it was really just you running the business (this is called trying to "pierce the veil" of the corporation or LLC). If the creditor were to succeed, you would be personally liable for paying the business's debts. Getting releases on all of your debts can avoid this, as can going through Chapter 7 individual bankruptcy.
On the other hand, if you are personally liable for some business debts because you signed some personal guarantees or because you're a sole proprietor or a partner, you'll absolutely need to get all of your creditors to settle with you and release your from the debts. If even one creditor refuses to release you from a debt you're personally liable for, all of your other settlements may be for naught, if the creditor sues you and takes your property or you end up having to file for bankruptcy anyway. Again, a business lawyer can help you keep this from happening.
Selling business assets and negotiating settlements yourself, rather than turning them over to a bankruptcy court for liquidation, will likely bring in more money for your creditors. And you won't have to pay the costs of bankruptcy (court and lawyers' fees). So if you feel an ethical duty to creditors and want to see that they receive as much money as possible, this may be the way to go. Keep in mind, though, that if you hire a lawyer to liquidate your company for you, these savings might diminish.
Managing the liquidation outside of bankruptcy also gives you far more control over which debts are paid. For instance, if you don't file for personal bankruptcy, you can choose to first pay the debts for which you are personally liable, such as:
You might even be able to buy the business's assets back yourself—something you might want to do if you are planning to start up a new business after the liquidation. For example, you might want to buy back a patent, copyright, or specialized technology to use in a new business. By contrast, in a Chapter 7 business bankruptcy, the bankruptcy trustee (the person in charge of gathering and selling the assets) may not let the owners of a corporation or LLC purchase the company's assets (though this is standard procedure for sole proprietors in individual Chapter 7 bankruptcies). Keep in mind that, especially if yours is a business that required little capital to start up, such as a service business, you can easily and legally start up a similar business after a Chapter 7 bankruptcy.
Finally, if before the liquidation you paid some creditors (perhaps family and friends) at the expense of others, these preference payments won't be taken away when you wind down your business yourself, as they would in bankruptcy. (For instance, if you made payments on a loan to a relative or close business associate in the year before filing, or transferred property for little or no payment in the two years before filing, a bankruptcy court could take back these payments or property to divide them equally among all creditors.)
First, it's a lot of work. It takes time to advertise and sell or auction off assets and to get each of your creditors to agree to a settlement.
Second, once you start negotiating, bankruptcy may not be an option. You often can't go back and file bankruptcy once you start liquidating assets and negotiating settlements yourself. That's because if you have made any preference payments or invalid transfers, these things will come back to bite you if you file for bankruptcy. For more information, see Nolo's article What Not to Do If You Might File for Bankruptcy.
Liquidating your own business and settling its debts outside of bankruptcy will take work on your part, and unless you have only a few debts and thoroughly understand the legal effect of each, is best done with the help of a lawyer who specializes in debt issues. Having a lawyer negotiate for you is often a big advantage if, as is likely, some of your creditors are no longer speaking to you. In addition, the lawyer will know how and when to mention the bankruptcy alternative in an effort to convince all of your creditors to accept your settlement as a better choice. If your creditors agree to settle, your lawyer can also help you prepare the necessary releases to be sure that, in exchange for your partial payment, you, your spouse, and any cosigners will be fully absolved from future liability. If you want this kind of help, connect with a local business lawyer.