Dissolution vs Bankruptcy: 6 Debts That Survive Closing the Entity

The first step in shutting down a business is to find out what the business’s debts are and which ones are tied to you personally. Neither a voluntary business dissolution nor a Chapter 7 bankruptcy will wipe those debts out. A corporation, LLC or partnership is not a dischargeable person. Creditors will then turn to you if you signed the business loans and leases. After a voluntary business dissolution, the entity continues to exist for years and can be sued if needed to enforce a debt.

What does a business bankruptcy filing do? When a store closes, a Chapter 7 filing will stop most lawsuits and collection for the time being. It lets the trustee sell off the business assets in an orderly way, and use what he can for unsecured creditors. It lets him undo payments made within 90 days before the filing. But Chapter 7 doesn’t eliminate personal liability or stop creditors permanently. A Chapter 11 case may help the business stay in business if the company can reduce what it owes or spread out the repayments over time.

Debt Will Outlive the Business

Six kinds of debt will outlive the business either way. A personal guarantee is a contract in which you agree to back up the corporation’s or the LLC’s debts. The federal government generally insists on personal guaranties from anyone with 20 percent or more of the stock or membership units in a small business seeking financing assistance from the U.S. Small Business Administration. Shutting down your business does not get you out from under SBA-guaranteed business debts like standard loans made through banks under the 7(a) program or the 504 loan program.

The loans under the COVID Economic Injury Disaster Loan program (EIDL) don’t just disappear when the business closes either. The SBA has to wait until your loan is 120 days late on payments before it can refer the loan to the Treasury Offset Program.

The trust fund portion of the payroll taxes - income taxes, Social Security, Medicare - are another matter. They can make you personally responsible, even without a personal guaranty. The IRS can move against you if it concludes you were the “responsible person” and willfully failed to pay taxes that were required to be withheld or deposited from employees’ wages. If it determines that the trust fund taxes, or “withheld income and employment taxes,” were not properly turned over to the government by the business, it can impose a 100 percent penalty on the “responsible person” or “persons” for the full amount of the unpaid taxes. After you are given 60 days to protest the proposed assessment, the IRS can place a lien on your personal property, seize personal bank accounts, and seize your home, cars or other assets.

The IRS’s trust fund penalty stands in the way of bankruptcy protection for the responsible persons. The trust fund portion of any taxes, no matter how old, qualifies as a priority tax and will not be erased even by a personal Chapter 7 bankruptcy that wipes out most ordinary debts. The money borrowed to pay the penalty is also not dischargeable.

For small businesses, the worst surprise of all can be the sales taxes. California makes responsible persons who willfully failed to pay them personally liable once the entity ends. In California, state tax officials have three years to go after anyone they deem to have been personally responsible for the business’s unpaid sales taxes after learning that the business has ceased, or eight years after it ceased, whichever period expires first.

Lawsuits against the dissolved corporation don’t just go away. It is still an entity and can still be sued by creditors or customers with claims against the business. In Delaware, a dissolved corporation can continue to exist for three years after its dissolution to be sued and settle debts. A stockholder who is handed assets from the corporation runs the risk of having to give them up to creditors in some circumstances. Delaware’s law caps personal liability for a stockholder to whatever the stockholder received from the corporation in the dissolution.

Another pitfall awaits: lienholders. A discharge takes care of debts but not liens. The threat of repossession of equipment or other property given as collateral on a loan survives a bankruptcy. Chapter 7 bankruptcy has its own drawbacks. The trustee sells your nonexempt personal assets and uses the proceeds to pay unsecured creditors. Exemptions from bankruptcy often depend on state law.

Tax Accounts

Shut down your books and close the tax accounts. Not a typo: closing your tax accounts is a separate matter from shutting down the business. The only way to have a chance to remove the business from the IRS’s active files is to file all of the business’s tax returns. None can be missing. That also means filing a final return. And you have to pay off all the business tax debts.

Whatever you do, don’t throw your payroll records away. They must be retained for at least four years. Last-minute tip: instead of a dissolution or bankruptcy, you might be able to work out something with your creditors before it gets that far. If there is any common ground to be found among your creditors, you may be able to find a way to wrap up the business without completely giving up everything you own.