Business Bankruptcy: 7 Facts Owners Learn Only After Filing

Many owners learn painful lessons too late. The reality is that bankruptcy is not the “get out of jail free” card you’d like it to be, and for business owners, it can be a real double-edged sword.

Corporations don’t get discharges in Chapter 7. A trustee will take over the company, and the owner can still be personally liable on any guarantees they gave or for taxes owed on payroll. Even payments out to creditors prior to bankruptcy may be clawed back. Employees are one group of creditors that can be paid before general unsecured creditors. Reorganizing under Chapter 11 is a lot more expensive.

Liquidation Bankruptcy

Some business owners might think a Chapter 7 bankruptcy would wipe out their business debts like it does for individuals. But no. Only individuals get Chapter 7 discharges. Corporations or partnerships are liquidated, but their debts are not wiped out.

In a Chapter 7, a court appointed trustee takes control of all assets, sells all nonexempt assets, and distributes proceeds to the unsecured creditors. A Chapter 7 trustee has the power to run the business, but only briefly and only if the court approves it.

Many debtors think bankruptcy is a blanket defense from collections or lawsuits. It isn’t. In most cases a bankruptcy will stop collection and garnishment, but not in every case, not always, and not necessarily for long.

The meeting of creditors is scheduled 21 to 40 days after you file a bankruptcy case. This meeting will be under oath, and the trustee will ask you about your debts, any property you have, and more. Make sure you bring all requested paperwork and account statements.

You may remain liable on business debts even if the business itself files for bankruptcy. Remember, the business went bankrupt, not you. If you have a small business and have personally guaranteed debts, your liability on that debt will continue past any liquidation of the business. If you, as an individual, had cosigned on the loan or provided a personal guarantee, you may still owe.

If you are filing Chapter 7 bankruptcy as the owner of a business, what can you keep? The general rule is that you may keep any property that is exempt, but you must turn over everything else to the bankruptcy trustee for liquidation and distribution to your creditors. What is “exempt” depends on the exemption scheme provided by state and federal law. Keep in mind that the court may deny a personal discharge for insufficient books and records; unexplained losses of assets; hidden or destroyed assets, or other acts of fraud or concealment.

Payroll taxes can come back to haunt you, even after your business closes. The IRS Trust Fund Recovery Penalty (more commonly called a “trust fund penalty”) is an assessed penalty against any person the IRS holds responsible for unremitted payroll withholding taxes. If a company that failed to pay payroll taxes keeps paying other creditors, it can be a clear indicator that an owner or officers willingly diverted the funds. 100 percent of the trust fund taxes that were not paid by the employer can become personal liabilities of the responsible party.

Many might be tempted to favor one creditor over another by making payments right before bankruptcy. Depending on how large the payment is, that can be money the trustee tries to claw back. In a bankruptcy, the trustee can reach back 90 days before filing to get paid back for preferential payments to creditors, or a whole year if the money went to insiders. There are exceptions for small transfers. If you have a business bankruptcy, transfers totaling under $8,575 cannot be clawed back as preferences if your debts are mostly business debts. A trustee might try to pursue claims under state law on certain transfers. This can happen if you transferred property to someone to keep the property out of bankruptcy and avoid your creditors.

When a business files for Chapter 7 bankruptcy, an order of priority determines which creditor gets paid first. There are six different priority classes, and each one has to be paid in full before the next class gets anything. The Bankruptcy Code does give a priority for unpaid employee wages owed just before bankruptcy. Wages earned within the 180 days before filing or shutdown, whichever came first, up to $17,150 per employee, are priority claims and will be paid before other unsecured creditors. The kinds of pay owed to employees include unused vacation time and sick days, along with severance.

Chapter 11

A Chapter 11 bankruptcy can keep the doors open, but it’s going to cost you. The filing fee is $1,167, there’s a $571 administrative fee, and a quarterly U.S. Trustee fee until the case closes. Outside Subchapter V, that fee is the greater of 0.40% of disbursements and $250.00 for cases with less than $1 million in disbursements, and 0.90% of disbursements, up to $250,000 for cases where disbursements are $1 million or more.

For smaller debtors, there is now a streamlined Chapter 11 process, called Subchapter V. In a Chapter 11 subchapter V, the debtor is the only one who submits a plan, and it must be submitted within 90 days of filing. If a Subchapter V plan is confirmed without the agreement of creditors, you must make at least the first three years of payments, or up to five years if the court orders it, before you get a discharge. A number of debts are not dischargeable in bankruptcy, even after five years of payments.

Going through a Chapter 11 or a Chapter 7 liquidation is a complicated process that can affect your business, your finances, your livelihood, and your future. Bankruptcy is serious business, and you need legal help before you decide if it’s what you need.

An Alternative to Bankruptcy

Before filing for bankruptcy, you should know there are other options. Creditors and borrowers can set up an alternative to bankruptcy.