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– Diane L. Drain

What is the process of declaring bankruptcy for a small business?

The following is provided by Cathleen Cooper Moran, of The Moran Law Group,
(reprinted with permission and for educational purposes only)

Corporations and partnerships are legal entities separate from their shareholders or partners. They can file Chapter 7 or Chapter 11 bankruptcy in their own right.

Proprietorship are just an extension of the owner: they can’t file bankruptcy alone.  Instead the proprietor must file bankruptcy, since the assets and the liabilities of the business are really just one form of assets of the proprietor. The individual owner may file Chapter 7, Chapter 11 or Chapter 13 (if the debt limits are met).

In a partnership’s Chapter 7 case, the trustee can sue the general partners of the partnership if the partnership’s assets are insufficient to pay all claims for the amount by which the partnership assets fall short of partnership debts. 11 U.S.C. 723. As a result, partners may be facing a suit by a trustee suing for the benefit of all creditors of the partnership.

To answer this question, you have to know what has caused the problems the business now faces and what are the prospects for change:

  • Reorganization can’t create a market; increase gross revenue, or make up for a poor fit between the skills available and the skills required to run the business.
  • Reorganization could free up cash from servicing the old debt to permit current operations; permit rejection of leases or contracts that are no longer advantageous (an expensive facility lease or improvident equipment purchase); or prevent the loss of vital assets or cash to creditor collection actions.

In between Chapter 7 liquidation and reorganization, a Chapter 13 or Chapter 11 could provide a breathing space for the owners to sell the business as a going concern or or its assets in something other than a fire sale. The resulting proceeds could pay taxes or unpaid salaries; sale of the business could provide ongoing jobs for the work force under new ownership. The bankruptcy could then be converted to Chapter 7 or dismissed if bankruptcy protection is no longer needed. The court will probably condition dismissal of the case on payment to creditors of the sale proceeds.

  • The company’s owners and officers need to know when business isn’t going well. When management is evaluating survival strategies and contingencies for closing, consider the following:
    • How much of the business debt is secured? The division of debt between secured and unsecured guides what reorganization can do for the business.
    • Is this debt secured? Hidden traps in proceeds from collateral Misuse of the the proceeds of a secured creditor’s collateral can create a non dischargeable debt for the individuals involved.
    • Trust fund taxes are not dischargeable: When an employer deducts taxes and social security contributions from employee wages, the employer becomes a fiduciary for that money which belongs to the employee. “Loaning” the business the money due Uncle Sam from employees’ paychecks makes the responsible corporate officers personally liable for the trust fund taxes not paid to the taxing authority. Sales taxes are trust fund taxes in some jurisdictions, as well.
    • Payments to insiders on old debts may be recoverable as preferential payments once the bankruptcy is filed. Repayments to relatives and business decision makers on their claims against the debtor can be recovered by the bankruptcy trustee under certain circumstances.

Bankruptcy reorganization in Chapter 11 requires significant time on the part of the owners and managers to comply with the requirements of the bankruptcy system. This option is far from inexpensive.

business bankruptcyThe business must have a very viable future in order to seek this remedy. Most reorganizations fail, usually for lack of the ability to stick to a budget, or to control the events and costs that forced the company into a bankruptcy. Many times the Debtor’s owner has no real idea how much time and effort goes into a successful chapter 11.

The value of the bankruptcy for the company and its owners/shareholders is that, in exchange for the protection of the automatic stay and other bankruptcy protections, the debtor provides full disclosure of its financial condition to creditors and the court, both at the beginning of the case and on a monthly basis in a form of a income and expense statement, and operates as a fiduciary for its creditors while the bankruptcy is ongoing. Meaning that the owner of the company must make decisions for the benefit of the creditors, not for his own benefit.

  • Businesses that require little capital, have few assets, or are really just extensions of the owner’s skills and personality are ones that it may not pay to reorganize. The owners may be better off liquidating the business, in or out of bankruptcy, and starting over in a fresh entity.

A Chapter 7, whether for the individual or a corporation, may be the best choice when:

  • the business has no future,
  • it has no substantial assets or qualities that cannot be reproduced, or
  • the debts are so overwhelming that restructuring them is not feasible.

Individuals can get a discharge of the dischargeable debts and a chance to start over. Corporations don’t get discharges, but a Chapter 7 can provide an orderly liquidation under the direction of the trustee and at no expense to the debtor. Creditors are assured that they will be paid to the extent of the assets available and the priority of their claim. Former management is assured that the assets that are available go (after the expenses of the Chapter 7) to pay taxes for which the individuals may be liable.