My last three blogs have dealt with the issues, problems and complications of closing a business that is no longer profitable. And I’ve written about using a personal chapter 7 bankruptcy as an option to protect an individual’s income and property from collection when business obligations have been personally guaranteed by a business owner. The focus has been on a personal chapter 7 as the most common option for a situation in which a small business has failed and the business owner now owes obligations to business creditors because the business can no longer honor the obligations. In this blog, I will write about the limited occasions in which an LLC or corporation should file a Chapter 7 Bankruptcy.
Why Chapter 7?
But before I get into those subjects, I wanted to mention why my initial reaction to dealing with the personal financial obligations of a business owner when a business is closing is a chapter 7 bankruptcy. The primary reason I think about chapter 7 is that business owners who have been working full time in their business are, when the business closes, at least temporarily in an uncertain financial position. A few business owners have an immediate source of income, from new employment or a new business ownership opportunity, so that they will have a predictable source, and a predictable amount of income. But for the vast majority of business owners, this happy scenario is not the case. Rather, the owner is looking at uncertainty regarding employment and income. Certainly the business the owner has been running cannot be counted on to provide a source of income. Since chapter 7 bankruptcy is a liquidation approach to debt problems, there is no ongoing financial commitment needed from the owner, who is in all likelihood not able to provide a meaningful commitment.
There is also the reality that the reason almost all business owners decide to file a personal chapter 7 bankruptcy is that the business in question has ceased to provide income for the owner. There is no income now, only debt that has to be paid. In these circumstances, I believe it is not in my client’s best financial interest to take “new” income away from my client to pay for debt that the business can no longer service. To a great extent, chapter 7 provides business owners with finality with respect to the business. The business has closed, and the filing of the personal chapter 7 bankruptcy allows the business owner to “close the books” on the business, both figuratively and literally.
Business Chapter 7 Bankruptcy
As I mentioned in an earlier blog, a great many clients of mine who own businesses come to see me thinking that the best outcome to their case would be to have the business file a bankruptcy case. But the underlying problem of the business failure is not usually that the business owes more money than it can afford to repay; rather, it is that the business owner has personally guaranteed this unaffordable obligation. So the conversation typically turns from the business filing a bankruptcy case to the owner filing a personal bankruptcy case.
Although it’s rare, there are some limited circumstances in which the business filing a bankruptcy case makes sense and should be pursued.
Remember that this is not an option when the business is a sole proprietorship or a general partnership. With sole proprietors and partners, all business debt is owed by the owner, only. So a sole proprietorship filing a “business” chapter 7 is not possible.
Limited Liability Companies (LLCs) and corporations, can, however, file a chapter 7 bankruptcy case. Why don’t more companies file a chapter 7? The simple reason is that the bankruptcy code provides that only people can receive the benefit of a bankruptcy discharge. The discharge is the order of the bankruptcy court, after a case has been completed that imposes a permanent injunction on creditors from collecting on debts owed to the creditors by individuals. The discharge of debt is the reason individuals file bankruptcy.
So with a discharge not available to a business, the attractiveness of a bankruptcy is significantly decreased. And this is particularly true when business owners become aware of the most common non-bankruptcy option available to business owners: that is, to simply close the business and notify creditors of the business closing. Once creditors know that the business is closing, the creditors can then take whatever recourse is available to them. For secured creditors, that will mean foreclosing on business-owned real estate or repossessing business inventory, equipment and fixtures in which the creditor has a security interest. Security interests are commonly granted in the accounts receivable of the business, and if there are unpaid receivables, the secured creditors can take steps to turn over collection of the receivables from the business to (usually) third-party collection agencies. Any unsecured creditors of the business can collect against the income coming in to the business, or the liquidation of business assets that are not subject to security interests.
If a business owner decides to file a chapter 7 bankruptcy case for the LLC or corporation, the bankruptcy trustee appointed to administer the case will determine what business assets are subject to a valid security agreement and will arrange to have the secured creditors take control of the collateral, and then will liquidate the unencumbered assets of the business. So in the example where the owner simply closes the business and notifies creditors, the creditors of the business recover and/or liquidate business assets. If there’s a bankruptcy case filed for the business, the bankruptcy trustee liquidates the business assets. In either scenario, the outcome is the same: the business assets are liquidated to pay creditors. And with the “orderly liquidation” approach set out in the preceding paragraph, the liquidation is conducted by creditors with the cooperation of the business owner. If there are charges made to facilitate the liquidation, the charges are typically minimal, and the creditors and business owner can apportion the costs by mutual agreement.
In a small business chapter 7, the bankruptcy trustee receives a commission that is approximately 20% of the amount paid to creditors. So the creditors receive less money in a hypothetical chapter 7 than in a private liquidation.
Once the assets of the business are liquidated, there really is nothing more the business’s creditors can “do” to the business. If the business has ended, and there are no more assets remaining of the business, the business owner is well advised to simply “walk away” from the business. At some point, assuming the business no longer pays renewal fees, the secretary of state’s office will administratively close the LLC or corporation.
For these reasons, in most cases a business chapter 7 is usually an unnecessarily expensive way to wrap up a business. But there are two scenarios in which an LLC or corporation filing a chapter 7 case makes sense.
When is a Business Chapter 7 a Good Idea?
There are two sets of circumstances in which a business chapter 7 can be a good strategy for business owners looking at closing their business. In the first scenario, the business has unpaid, overdue taxes, and the business has assets that have value but that are difficult to collect. Usually the difficult-to-collect asset are unpaid accounts receivable. One of the truisms of operating small businesses is that once a business finds itself in financial trouble, and the word spreads in the community that the business may not be able to remain open, collecting receivables becomes incrementally more difficult. Customers simply stop paying when they hear that the business may not be open long-term, and customers will look for alternatives to the product or service that the troubled business sells.
When a business that is closing files a chapter 7, the chapter 7 bankruptcy trustee is charged with liquidating the assets of the business. In a case where there are unpaid receivables that are completely, or partially free of security interests, the trustee will collect the receivables to the extent possible and then pay unsecured creditors with the money collected.
When the trustee pays unsecured creditors, there is a priority of payment. Unsecured creditors are classified as being either priority unsecured creditors or general unsecured creditors. There are several classifications of priority creditors - unpaid employees and child support recipients who are owed back child support are two examples. Taxes are also priority debts. The rule is that priority claims are paid from the assets of a bankruptcy estate in full before general unsecured creditors receive any payments.
It is typical that a business that has financial problems also has tax problems - usually in the form of unpaid withholding taxes. In a case where a business has accounts receivable but the owner of the business has been unsuccessful in collecting the receivables, the business owner might consider filing a chapter 7 bankruptcy on behalf of the business to put a bankruptcy trustee, who has more resources and more motivation (remember the trustee’s commission!) to collect the receivables. When the trustee collects the receivables, the trustee will then pay priority claims, such as taxes. And if the trustee is able to collect a high percentage of the receivables it is possible that most or even all of the business’s tax liabilities can be paid.
Why is this a good thing? Because unpaid business tax liability will eventually become the personal liability of the business owner. So in some cases where tax liability is present, the business owner is well-served to have the business file a chapter 7 case. The trustee can collect receivables more effectively than the owner, and the receivables will pay a significant portion, if not all, of the tax debt, which will, if not paid, eventually become the personal responsibility of the business owner.
The other scenario in which filing a business chapter 7 makes sense is when the business, and/or the business owner is involved in litigation with creditors. In many cases, the business owner in this scenario is the defendant in a collection lawsuit, along with the LLC or the corporation, for personally guaranteed business debt. The business has defaulted on its obligation and lacks the assets to pay the creditor. The creditor sues the business, looking for a judgment against the corporation that will allow the creditor to liquidate the business’s assets, but the creditor also sues the owner who has personally guaranteed the business’s obligation.
When this happens it is appropriate for the owner to file a personal bankruptcy case to protect the owner’s income and assets from the creditor. And in most cases where the owner of a failing business has filed a personal bankruptcy case, that filing is enough to reduce the impact of the lawsuit for the owner and the owner’s business. In many cases like this, the creditor will dismiss the complaint against the owner, and simply obtain a judgment against the business and play a “wait and see” game to check if the business comes into any money or otherwise obtains an asset. In essence, the litigation (and the expenses that accompany litigation) ends. But that does not always happen. In some instances, the filing of a bankruptcy by the owner of a failing business will only get the business owner out of the fray - the litigation against the business, involving discovery, pre-trial appearances and, potentially, a trial continues. The cost of litigation, if there is no insurance coverage for the business, then would have to be borne by the business owner. That is an expense that almost every business owner in this situation cannot bear. When a business involved in litigation files a chapter 7 bankruptcy case, the automatic stay that is issued will at least temporarily stop the litigation (and the cost of litigation).
Because the chapter 7 trustee has a duty to liquidate the assets of a business before the chapter 7 case is closed, the lawsuit plaintiff is in a position that after the case is closed, there are literally no assets remaining to liquidate. In that circumstance, while the plaintiff might still seek a judgment against the business, there is a virtual guarantee that no expensive litigation will take place. That’s enough for this week - next week we’ll look at chapter 13 as a tool for distressed businesses.