How to Declare Insolvency: 6 Facts About a Term With No US Filing Attached

An American business cannot declare insolvency, because there is nothing to declare it to. No federal form bears that title, no state office accepts one, and a letter from an owner announcing the condition to creditors changes the owner's legal position about as much as a thermometer changes the weather.

Insolvency in the United States is a measurement. Several bodies of law take that measurement for their own purposes, and each one asks the question at a different moment and for a different reason. What an owner searching for how to declare insolvency usually wants is the next step, and the six facts below lead there by way of the definitions.

1. The Word Describes a Balance Sheet, Not a Filing

Federal bankruptcy law defines the term and then does very little with it at the door. Under section 101(32) of the Bankruptcy Code's definitions, an entity other than a partnership or municipality is insolvent when "the sum of such entity's debts is greater than all of such entity's property, at a fair valuation," leaving aside property the debtor has hidden or moved to defeat creditors and property an individual may exempt.

Two phrases carry the weight. "Fair valuation" means the court does not accept the book value on the owner's balance sheet as given; equipment that cost $90,000 may be worth a third of that at auction, and receivables from a customer who stopped paying may be worth nothing. And "debts" includes obligations an owner tends to leave off an informal tally, such as taxes assessed but not yet paid, or the rent remaining on a lease with years still to run.

The result is a condition that exists whether or not anyone announces it. A company can be insolvent on a Tuesday without its owner knowing, and the law will later say it was.

2. Bankruptcy Does Not Require It

Section 109 of the Code, which lists who may be a debtor under each chapter, contains an insolvency requirement in exactly one place: chapter 9, which is reserved for municipalities. The chapters a business would use, chapter 7 and chapter 11 (including Subchapter V), carry no such condition. A company may file while its assets still exceed its debts.

Courts can dismiss cases for cause, and a filing with no financial purpose invites that result, but the petition itself asks no solvency question. The word the searcher typed is, for filing purposes, the wrong word.

3. State Law Uses the Same Test and Adds a Presumption

Voidable transaction statutes, the state laws that let creditors unwind certain transfers, take the measurement again. New York's version, in section 271 of the Debtor and Creditor Law, provides that "a debtor is insolvent if, at a fair valuation, the sum of the debtor's debts is greater than the sum of the debtor's assets." It then adds a rule the federal definition lacks: "A debtor that is generally not paying the debtor's debts as they become due other than as a result of a bona fide dispute is presumed to be insolvent."

That presumption is the closest American law comes to treating conduct as a declaration. An owner who stops paying suppliers and funders across the board has, for New York's purposes, supplied the evidence without writing a word, and the burden then shifts toward showing that the balance sheet says otherwise. The neighboring section 273, in its list of warning signs for a suspect transfer, includes insolvency, a transfer to an insider, and a transfer made while a suit was pending or threatened. Which is where the measurement stops being abstract. The owner who moves the delivery van to a cousin in the month the funder's lawyer calls (and it is usually a van, or a truck, or the one piece of equipment that still has resale value) has assembled most of those signs in a single afternoon.

4. The Tax Code Measures It Again, Immediately Before a Debt Is Forgiven

When a creditor forgives debt, the forgiven amount can become taxable income. Section 108 of the Internal Revenue Code excludes it in two relevant situations: when the discharge occurs in a bankruptcy case, and when it occurs while the taxpayer is insolvent, in which case the exclusion "shall not exceed the amount by which the taxpayer is insolvent." For this purpose insolvency means "the excess of liabilities over the fair market value of assets," measured immediately before the discharge.

The IRS collects the answer on Form 982, which the instructions say is filed "with your federal income tax return for a year a discharge of indebtedness is excluded from your income under section 108(a)." Publication 4681 contains a worksheet for the calculation. The instructions also state that the insolvency exclusion does not apply to a discharge that occurs in a title 11 case, where the bankruptcy exclusion governs instead. Excluded amounts reduce the taxpayer's tax attributes, and for a partnership the test is applied partner by partner while an S corporation applies it at the corporate level.

This is the one setting in which an owner does, in a sense, declare insolvency on a federal form. The declaration arrives after the settlement rather than before it, and it is a number, attested on a tax return, rather than a status.

5. What an Insolvent Company Actually Does Next Comes in Four Forms

The first is a bankruptcy petition, which does have a form: chapter 11 or Subchapter V for a company that intends to keep operating under a plan, chapter 7 for one that will be liquidated by a trustee. An LLC or corporation receives no discharge in chapter 7, and its owners' personal guaranties survive whatever happens to the company.

The second is an assignment for the benefit of creditors, a state-law route in which the company transfers its assets to an assignee who liquidates them for creditors. New York governs it under Article 2 of its Debtor and Creditor Law, titled "General Assignments For the Benefit of Creditors," with proceedings before the court in the county where the assignment is recorded. The procedure differs by state and belongs to counsel.

The third is dissolution under the state's corporate or LLC statute. Dissolving the entity ends its existence on the state's records; it does not make its creditors disappear, and New York's corporate statute provides a notice procedure through which a dissolved corporation may require claims to be presented by a deadline.

The fourth is a workout, meaning a negotiated arrangement with creditors outside any court. It binds only the creditors who sign it and offers no automatic stay against those who do not. Delancey Street, a debt settlement company and not a law firm, works in this fourth category, and the honest limit of that work is that it depends on creditors agreeing.

6. Directors of an Insolvent Delaware Corporation Do Not Answer to Creditors Directly

Owners sometimes fear that insolvency makes them personally answerable to every creditor for how they ran the company. For Delaware corporations the state's highest court addressed this in 2007, in North American Catholic Educational Programming Foundation v. Gheewalla, holding that creditors of a corporation "that is either insolvent or in the zone of insolvency have no right, as a matter of law, to assert direct claims for breach of fiduciary duty against the corporation's directors." Creditors of an insolvent corporation may pursue such claims derivatively, on the corporation's behalf.

The decision is Delaware law for Delaware corporations. Other states, and LLCs, need their own answer.

The First Review Before the Fifth Section's Choice

Delancey Street reads, without charge and in confidence, a company's merchant cash advance contracts, bank activity, and liens, and it works with independently licensed counsel whenever a question becomes a legal one. It files nothing in any court. A company whose balance sheet shows debts far beyond anything creditors would compromise, or one already facing levies and a sale date, belongs with bankruptcy counsel, and the review should say so plainly when that is the answer.

Insolvency, measured four ways by four bodies of law, turns out to be the one thing about a failing company that nobody has to announce. The decision about what to do with it is the part that still requires a signature.