What Not to Do If You Might File for Business Bankruptcy

By , Attorney

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 make good sense anyway.

Don't Make Preference Payments to Creditors

If a friend, relative, or business associate has lent you money, you may 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 make during the year before the filing, to make sure that some creditors weren't given an unfair advantage (called "preference payments"). The trustee will want to "recapture" (take back) any preference payments you made to creditors within one year if those payments were made to a relative or close business associate (an "insider")—and will divide them equally among all creditors. If your relatives or associates can't come up with the money that you paid them, the bankruptcy trustee can sue them to recover it.

You are legally allowed to pay one unsecured creditor ahead of the others if the creditor is not 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 at payments you made to these regular creditors. The trustee can make a company that was paid "disgorge" (return) payments of over $5,475 and spread the money among all of your creditors. (But if fewer than 51% of your debts are from your business operations, the trustee can force a company to disgorge only payments of more than $600.)

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

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, none of the money you borrowed can be paid back, even if your business property is sold and the proceeds distributed to your creditors. That's because the bankruptcy court is likely to classify a loan from a relative or close associate as a gift, not a loan. (For other ideas, see our article on alternative methods of borrowing.)

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 will 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.

EXAMPLE: Julieta runs an insurance brokerage with five employees. When her sales slump for three months in a row, Julieta realizes she has to cut her biggest expense: payroll. She cuts her salary from $8,000 per month to $4,000. Two months later, business hasn't picked up, and she finds herself with even lower sales and $120,000 in personally guaranteed debt. With her creditors threatening lawsuits, she decides to file for Chapter 7 personal bankruptcy.

In the last month of business, she is able to collect an $8,000 commission payment from a client insurance company. Reasoning that she gave up $8,000 in salary over two months, she repays herself the $8,000 before filing for bankruptcy. After she files, the court requires her to pay back the $8,000 to the bankruptcy trustee. Fortunately, the bankruptcy judge does not find that her intent was fraudulent, so her bankruptcy case is not dismissed.

Don't Go on a Shopping Spree

Some people, realizing that bankruptcy is inevitable, grab whatever cash they can and buy a car, luxury items, or go on a trip before they file. Another bad idea. If you buy luxury goods or services within three months of filing, you are considered to have had the intent to defraud the bankruptcy court, and the resulting debts won't be discharged in bankruptcy.

Even if you make big purchases, such as a vacation time-share, country club dues, or a pricey new wardrobe, more than three months before filing, the creditor can still claim that your intent was fraudulent and you never meant to pay the money back—but in this case, the creditor has to prove that your intent was fraudulent. If the creditor is successful, these debts won't be discharged in bankruptcy.

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

If you are 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, which can result in the dismissal of your bankruptcy case or even criminal charges.

Avoid Taking 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 consequence, 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 over $825 taken within 70 days of filing for bankruptcy is usually nondischargeable. Lesser amounts should be dischargeable unless the creditor argues successfully that you had no intent to pay the money back.

Don't Pay Off Your Car Loan

Many people erroneously believe that they get to keep one car when they file for bankruptcy (regardless of the amount of equity). 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 more information, see our section on bankruptcy exemptions.

Don't Panic About Utilities or Your Lease

If you declare bankruptcy, the utility companies can't use this as an excuse for immediately shutting 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. Similarly, as long as you keep paying your rent, 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 will try to soldier on with your business postbankruptcy 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 to cover unknown liabilities, 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.

Don't Pay All of Your Unsecured Debt

If you are 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 will 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.

Consider Selling Some Nonexempt Property

If you own valuable property that you are likely to lose in a Chapter 7 bankruptcy, such as a boat, vehicle, or business equipment, you might be able to sell it before you file and use the proceeds to pay personally guaranteed loans and bankruptcy fees. However, you shouldn't use the proceeds 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 filed against you. For more information, see our article on selling nonexempt property before bankruptcy.

Next Steps

To learm more about alternatives to bankruptcy and bankruptcy, see Nolo's section on Small Business Bankruptcy.

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