How to Bankrupt a Business: 6 Lines an Owner Should Not Cross Before Filing

An owner may lawfully take a business into bankruptcy, and the Code is written on the assumption that many will. What the Code punishes is the conduct that sometimes comes first, in the months when the owner can see the end approaching and begins, with the best of intentions or the worst, to arrange it.

Anyone asking how to bankrupt a business should hear the answer in two parts. The filing itself belongs to bankruptcy counsel. The period before it belongs to the owner, and the six lines below are the ones that period most often tempts an owner to cross. Each has a statute waiting on the other side.

1. Property Moved to Family Can Be Brought Back

The company pickup is signed over to a brother-in-law for a dollar. The equipment goes to a new entity owned by a spouse. Money moves to a relative's account "for safekeeping." These transactions feel like protection. In bankruptcy they are evidence.

Under 11 U.S.C. 548(a)(1), a trustee may avoid any transfer made within two years before the petition either with "actual intent to hinder, delay, or defraud" a creditor, or for "less than a reasonably equivalent value" while the business was insolvent, was left with unreasonably small capital, or expected to incur debts beyond its ability to pay. The second branch requires no intent at all. A pickup worth thousands transferred for a dollar by an insolvent company is avoidable on its arithmetic alone, and the explanation that the relative had worked for years without pay (a justification owners sometimes offer) does not supply the missing value unless it was a real, documented debt.

The two years are not the outer limit. Section 544(b) lets the trustee use any state voidable transfer statute available to an actual unsecured creditor, and those statutes carry their own lookback periods, which vary by state and which counsel will have to read. The Statement of Financial Affairs, meanwhile, asks the company to list every transfer outside the ordinary course made within two years before filing, including transfers made as security. What begins as a question about the pickup becomes, soon enough, a question about the owner's credibility in every other answer on that form, and it is the credibility, not the pickup, that tends to decide how the rest of the case goes for the people who run the company.

An owner who later files personally faces one more consequence. An individual who, within one year before the petition, transferred or concealed property "with intent to hinder, delay, or defraud a creditor" may be denied a discharge altogether under section 727(a)(2).

2. Paying Yourself First Extends the Lookback to a Full Year

Preferential payments to ordinary creditors can be recovered if made within 90 days before filing. For insiders, meaning officers, directors, persons in control of the company, and their relatives, section 547(b)(4)(B) extends the period to one year. Repaying the owner's loan to the company or accelerating the owner's salary are the transfers the insider period was drafted to reach, and the company's sworn disclosures separately ask about payments on debts the owner personally guaranteed.

Official Form 207 asks the question in plain language, requiring the company to disclose any value given to an insider within one year "in any form, including salary, other compensation, draws, bonuses, loans, credits on loans." The answer is signed under penalty of perjury.

3. New Credit Taken With No Plan to Repay Follows the Owner

A third merchant cash advance signed in the final weeks, on an application showing revenue the business no longer earns, is the kind of transaction that invites scrutiny. Stacking advances is not, by itself, fraud. A materially false statement of financial condition, however, is a different matter.

The Code's discharge exceptions in section 523(a)(2) apply to individual debtors, which matters because the owner who signed a personal guaranty is an individual. A debt obtained by "false pretenses, a false representation, or actual fraud," or through a written statement about financial condition that was "materially false," reasonably relied on, and made "with intent to deceive," may be excepted from the owner's personal discharge. The creditor must ask for that result: under section 523(c)(1) such a debt is discharged unless the creditor requests otherwise and the court so determines after a hearing, and the request must generally be filed within 60 days after the first date set for the meeting of creditors.

The company's own discharge, if it obtains one in Chapter 11, raises separate questions, or, more accurately, questions under separate provisions that counsel should examine before anyone assumes the answer. For the owner, the guaranty is where the risk concentrates.

4. Hidden Assets Turn a Civil Case Into a Criminal One

The federal bankruptcy fraud statute, 18 U.S.C. 152, punishes anyone who "knowingly and fraudulently conceals" estate property from a trustee, creditors, or the U.S. trustee, or who knowingly and fraudulently makes a false oath or account in a bankruptcy case, with imprisonment of up to five years. The petition itself warns, citing that statute together with several others, that false statements "can result in fines up to $500,000 or imprisonment for up to 20 years, or both."

Nobody hides a forklift well.

Records count as well as property. An individual who "concealed, destroyed, mutilated, falsified, or failed to keep or preserve" the records from which a business's affairs could be reconstructed may be denied a discharge under section 727(a)(3). The bookkeeping that seemed optional during the good years becomes, in a case, a thing the owner must produce.

5. A Fire Sale of Inventory Is Still a Transfer

Selling inventory at a deep discount to raise cash is not unlawful. Selling it for less than reasonably equivalent value while insolvent can be avoided under the constructive branch of section 548, and a sale to someone connected to the owner draws the closest attention. The trustee will ask what the goods were worth and who bought them.

And in New York, a business required to collect sales tax that sells its assets in bulk, outside the ordinary course, triggers a separate rule: the buyer must notify the Tax Department at least ten days before taking possession or paying, or become personally liable for the seller's unpaid sales taxes up to the greater of the purchase price or the fair market value of the assets. A buyer who knows the rule will want the notice filed before closing.

6. Unpaid Trust Fund Taxes Survive Every Filing

Withheld employee taxes follow the responsible person through the company's bankruptcy and, ordinarily, through the owner's own. The IRS may assess a penalty equal to the unpaid trust fund tax against any responsible person who willfully failed to pay it over, and "willfully," in the agency's words, requires no "evil intent or bad motive."

The Supreme Court held in United States v. Sotelo (1978) that an officer's liability for withheld taxes was not dischargeable, and the current Code reaches the same result by giving priority to a withheld tax "for which the debtor is liable in whatever capacity" and excepting it from an individual's discharge.

No settlement company can negotiate that penalty away. It is a matter between the owner and the IRS.

What Lies on the Lawful Side of the Line

Delancey Street, which settles business debt and is not a law firm, cannot advise on any of the conduct above and does not represent owners in bankruptcy or before the IRS. What it provides is a free, confidential initial review of whether a business's advances and other obligations might be negotiated to a resolution without a filing, with independently licensed counsel involved wherever a legal question appears. An owner who has already crossed one of these lines needs bankruptcy counsel first, and should tell that counsel everything.

A business can fail honestly. Most of what makes a bankruptcy go badly for an owner is done in the months when the failure was already visible and the owner tried to manage what the law was about to manage instead.