Partnership Bankruptcy: 6 Rules on Partner Liability Under §723

Although a partnership can file bankruptcy, this does not release the partners from their joint liability for the partnership’s debts. Chapter 7 bankruptcy for a partnership doesn’t get them out of trouble. This kind of filing doesn’t even give the partnership a discharge. The general partners stay liable for the business’s debts, and the trustee is authorized to go after the partners for the money, using Section 723. For these reasons, a partnership may not benefit from a Chapter 7 filing. Worse, it may make it more likely that general partners get sued over the partnership’s debts. The six rules below explain why.

When a partnership files a Chapter 7, the trustee sells any business assets and pays creditors whatever they receive. Usually, the trustee shuts down the business. There is an exception for rental properties, though; the trustee may collect the rents until the property sells.

On the Hook for Everything the Partnership Owes

As a general partner, you’re on the hook for everything the partnership owes. Limited partners, though, are usually only liable for any debts they personally guaranteed. A limited liability partnership (LLP) may have different rules set by state law. However, the trustee’s claims stop where the law stops, and some states have adopted partnership rules that may give you relief as a partner. Under the Uniform Partnership Act of 1997, only the partnership - not individual partners - is liable for debts incurred while it was an LLP. Partners who joined after the debts were incurred aren’t liable for them.

Outside the bankruptcy, creditors sometimes sue general partners - and usually they only go after some of the partners, not all. The partners likely pay off a portion of the debt. When the partnership files a Chapter 7, the trustee can sue the general partners. Instead of a claim against the partners for a small part of the debt, they’re getting sued for the total unpaid claims, minus the amount the bankruptcy trustee got from selling the business assets.

The trustee may choose to sue just some of the partners, depending on which ones have the most to lose. Even if only one partner gets sued for the shortfall, that person can be on the hook for all of it. And if one partner does take the hit for the rest, they can turn around and sue the other partners for contribution outside the bankruptcy.

Determining the total deficiency is going to take some time. To prevent transfers that frustrate the trustee’s attempt to collect the shortfall, the court may put a temporary hold on any personal assets belonging to the general partners, or require them to put up a bond or other assurance of payment. Before a trustee can go after any partner who also filed for bankruptcy, the trustee must, where practicable, first try to collect from other partners who aren’t in bankruptcy.

If a partner is also in bankruptcy, the trustee of the partnership gets a claim in the partner’s case for the total amount of all allowed claims in the partnership bankruptcy, and all joint claims are disallowed unless secured only by the property the partner owns. Any surplus left over after paying the partnership’s bankruptcy deficiency is returned to the partners’ estates, but only after a hearing in the bankruptcy court.

Suing the Partners Who Signed Guarantees

It gets worse. The bankruptcy doesn’t stop creditors from suing the partners who signed guarantees. They can go after partners personally, while the partnership case is still pending. Limited partners can lose their investment, and sometimes they can be sued on personal guarantees. Under Illinois law, a creditor with a judgment against a personally liable partner can levy on that partner’s personal assets without first exhausting partnership assets. This is the case when the partnership is in bankruptcy.

General partners count as insiders under the bankruptcy rules, so payments to them within a year before the bankruptcy can be undone by the trustee, instead of the usual 90 days. Partnership taxes still pass through to partners, and the trustee files the return.

Chapter 13

Partnerships cannot use Chapter 13; only individuals can. There’s a Chapter 11 for small businesses, but it’s only available if the partnership’s total debt is $3,424,000 or less on the filing date. So if you’re a partner, you have to weigh the impact on you personally. Figure out what joint, several, and contribution liabilities you face.