What Not to Do If You Might File for Business Bankruptcy

Avoid common bankruptcy pitfalls. Here’s a guide to what not to do before filing for business bankruptcy.

By , Attorney · UC Law San Francisco
Updated by Amanda Hayes, Attorney · University of North Carolina School of Law

If you decide that personal or business bankruptcy might be the best strategy for getting rid of your business debts, you'll need to plan ahead to steer clear of some common missteps. Fortunately, even if you end up solving your debt problems without bankruptcy, these tips for what to not do before filing for bankruptcy can help your business.

The guidance in this article applies to both business bankruptcy and personal bankruptcy for business owners looking to protect their businesses.

Don't Pay Off Some Kinds of Debt Before Filing for Business Bankruptcy

Before you start making payments and restructuring your finances, you'll need to make sure you're making the right payments. If you make certain loan payments, that money could be later reclaimed or wasted.

You'll need to consider your personal and business assets and debts, regardless of whether you file for personal or business bankruptcy. On the one hand, your personal assets can be scrutinized in business bankruptcy—usually when you're personally liable for business debts. On the other, filing for personal bankruptcy can help with your business debts. Bottom line: Personal and business assets and debts can be important in both kinds of bankruptcy.

Don't Make Preference Payments to Friends and Relatives

If a friend, relative, or business associate has lent you money, you might be tempted to try to repay some or all of it before filing bankruptcy. Bad idea.

When you file for bankruptcy, the bankruptcy trustee will scrutinize all payments you made during the year before the filing to make sure that some creditors weren't given an unfair advantage, receiving what are called "preference payments."

The trustee will want to "recapture" (take back) any preference payments you made to creditors who are relatives or close business associates ("insiders") within one year of the bankruptcy filing. The trustee will then divide those payments equally among all creditors. If your relatives or associates can't come up with the money that you paid them, the trustee can sue them to recover it.

In the year before filing bankruptcy, you're legally allowed to pay one unsecured creditor ahead of the others if the creditor isn't a close relative or associate. For example, you can choose to pay the business line of credit that you signed a personal guarantee on before you pay your suppliers. The bankruptcy trustee will, however, look back 90 days from your bankruptcy filing at payments you made to this kind of regular creditor to make sure any payments you made were allowed.

Once you've filed bankruptcy, the trustee can make a company that you wrongly paid "disgorge" (return) any preference payments if you collectively paid out, as of 2022, more than $7,575. The trustee will then spread the money among all of your creditors. But if less than 51% of your debts are from your business operations and expenses, the trustee can force you to disgorge payments you made only if your total payments were more than $600. (11 U.S.C. § 547(c) (2022).)

Don't Pay Off Your Car Loan

Many people wrongly believe that they get to keep one car when they file for bankruptcy, regardless of the amount of equity in their car. So they do whatever they can to pay off their car loan before they file.

In truth, under the exemption laws of most states, you get to keep only a limited amount of equity in a vehicle, typically $1,000 to $5,000. If you have more equity in your car, the bankruptcy trustee will grab it to pay down your debts.

So find out your state's equity limit for vehicles and stay within it. For instance, let's assume that you have $3,000 equity in your car (your car is worth $5,000 but you owe only $2,000 on it). If your state's equity limit were $3,000, you wouldn't want to pay any more on the loan because you would end up with more equity in the car than can be protected.

For more information, see our section on bankruptcy exemptions.

Don't Pay All of Your Unsecured Debt

If you're certain that you'll file for bankruptcy and there are certain unsecured debts you plan to wipe out, such as credit card bills and medical bills, it often makes sense to stop paying anything toward them. They'll normally be fully discharged in bankruptcy, so you don't really gain anything by paying them down now.

Better to put the money toward:

  • secured loans, such as your mortgage or car loan, and
  • debts you're personally liable for, such as payroll taxes or bankruptcy fees.

Just be really sure the unsecured debt you stop paying on is dischargeable in bankruptcy before you stop making payments.

Don't Do Anything That Could Be Considered Fraudulent

Building your equity or splurging on the finer things before taking the plunge into bankruptcy can seem tempting. But giving into that temptation can be considered fraud and lead to your bankruptcy case being dismissed—or worse, criminal charges.

Don't Take Equipment or Supplies From Your LLC or Corporation

If you're headed into bankruptcy, taking goods from your LLC or corporation—like laptops, forklifts, vehicles, inventory, or supplies—is considered stealing from your creditors and bankruptcy fraud. An LLC or corporation owner who takes goods in this context can face dismissal of their bankruptcy case and even criminal charges.

Don't Pay Yourself a Bonus or Back Pay

The bankruptcy system treats you like an insider creditor. So if you pay yourself a bonus, repay a loan you made to the business, or otherwise take money out of the company during the 12 months prior to filing for bankruptcy, it'll be considered a recoverable preference payment. It might even be considered bankruptcy fraud, which can result in jail time, or at least in the dismissal of your bankruptcy case.

Don't Go on a Shopping Spree

Some people, realizing that bankruptcy is inevitable, grab whatever cash they can and buy a car or luxury items, or go on a trip before they file. Another bad idea.

If you buy luxury goods or services totaling more than $800—such as a vacation timeshare, country club dues, or a pricey new wardrobe—within three months of filing, you're considered to have had the intent to defraud the bankruptcy court, and the resulting debts won't be discharged in bankruptcy. (That amount is as of November of 2022 and applies to cases filed on or after April 1, 2022). (11 U.S.C. § 523(a)(2)(C)(i)(l) (2022).)

But when you spend the money in this way more than three months before filing, the creditor has to prove that your intent was fraudulent. If the creditor is successful, these debts won't be discharged in bankruptcy.

If you're found to have knowingly deceived the court—for example, by trying to hide your purchases—you could also face criminal charges.

Don't Take Cash Advances on a Credit Card

If you take a large cash advance on a credit card before filing for bankruptcy, the credit card company can assert that you were trying to defraud it and that you had no intent of paying the money back. In this sort of situation, the bankruptcy trustee can treat the cash advance as a nondischargeable debt, or even throw your case out of court entirely because of it.

Any cash advance more than $1,100 taken within 70 days of filing for bankruptcy is usually nondischargeable. (This amount is as of November 2022 and applies to cases filed on or after April 1, 2022). (11 U.S.C. § 523(a)(2)(C)(i)(l) (2022).)

Lesser amounts should be dischargeable unless the creditor argues successfully that you had no intent to pay the money back.

Don't Pay Off Loans on Exempt Property With Proceeds From Selling Nonexempt Property

If you own valuable property that you're likely to lose—that is, nonexempt property—and you're filing for Chapter 7 bankruptcy, you might be able to sell it before you file and use the proceeds to pay personally guaranteed loans and bankruptcy fees once you file.

Valuable property could include:

  • a boat
  • a vehicle, and
  • business equipment.

However, you shouldn't use the proceeds from selling this kind of property to increase your exempt property—for example, paying the proceeds toward your mortgage when your home equity will be protected by your state's homestead exemption. If you do, and the court determines that you intended to defraud your unsecured creditors, your case could be dismissed and charges could be filed against you.

For more information, see our article on selling nonexempt property before bankruptcy.

Avoid Other Common Missteps Before Business Bankruptcy

Bankruptcy can be scary, and it might be hard to know when you should start expecting it. When you're in financial trouble, take preemptive measures to protect yourself and loved ones that helped you with your business.

Don't Borrow From Friends or Family Unless They Can Afford to Lose It

If you borrow money from family and friends to repay your business debts but then end up filing for bankruptcy, you won't be able to pay them back. Even if your business property is sold and the proceeds are distributed to your creditors, your loved ones won't get a slice. Your friends and relatives can't be repaid because the bankruptcy court is likely to classify money from a relative or close associate as a gift, not a loan.

Even if you don't plan to file for bankruptcy any time soon, you should consider—as good business practice—alternative methods of borrowing so friends and family can contribute to your business without the contribution being classified as a gift. For instance, your sister can be an equity investor or your friend can be a shareholder in your corporation.

Don't Panic About Utilities or Your Lease

The utility companies can't use your declaring personal or business bankruptcy as an excuse to immediately shut off services (although they can require you to post a reasonable deposit to keep on the lights, phone service, and heat). As long as you pay future bills on time, you should be fine. (For more information, see our article on how to use a Chapter 7 bankruptcy to prevent a utility shut-off.)

Similarly, as long as you keep paying rent on your home or business, your landlord can't evict you. Don't be spooked by the clause—common in commercial leases—that says that you're automatically in default (in violation of your lease) if you file for bankruptcy. These clauses are generally not enforceable (except against sublessees and assignees).

Don't Keep Leased Property

If you're leasing equipment and are going out of business, return the equipment to the leasing company before you file for bankruptcy. No doubt the company will bill you for the amount owed under the remainder of the lease, but this debt will be discharged in bankruptcy.

On the other hand, if you try to soldier on with your business post-bankruptcy and want to keep leased property, you'll need to keep making payments on time. Your obligation won't be discharged by your bankruptcy because the debt is secured by the equipment.

Don't Let Your Insurance Coverage Lapse

If you need to keep your liability insurance in force because you think some unknown claims might surface later, you should file for bankruptcy just after you renew your policy. That's because when you file, you'll want to have insurance in place that extends at least 12 months into the future. Otherwise you may have a tough time finding an insurance carrier willing to renew your business coverage or issue a new policy.

As long as you continue to pay on time for existing coverage, the insurance can't be canceled because of your bankruptcy, and you'll enjoy some peace of mind.

Help With Business Bankruptcy

To learn more about alternatives to bankruptcy and bankruptcy itself, see our section on Small Business Bankruptcy. If you think filing could make sense for you, talk to an attorney who has had experience with bankruptcy cases like yours. They can help you figure out which debts will need to be paid back and which will be discharged, and what property you can keep. They can also help you develop a strategy and represent you in court, if necessary.

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