If Your Business is Eligible to File Bankruptcy, Should It Do So?

Posted by Kevin on April 15, 2017 under Bankruptcy Blog | Be the First to Comment

Most small businesses do not have any reason to file bankruptcy after they fail. Instead it’s the individual owner or owners of the business who may well have to think about bankruptcy.

Business Corporation Is No Shield for Owners of Small Businesses

Why does a small business owner sets up his or her business as a corporation?  One reason is a concept called limited liability.  The corporation is legal entity that is separate from its owners.  A corporate debt is just that- it is a debt of the entity and not its owners.  In other words, the investor-owners of the business are not liable for those business debts. That’s the theory.

But in practice it doesn’t work that way, not with small businesses. Why? Because:

• Many new businesses cannot get any credit at all, and so have to be financed completely through the owner’s personal savings and credit. This credit tends to include credit cards, second mortgages on homes, vehicle loans, and personal loans from family members.
• For those businesses fortunate enough to receive financing in the name of the corporation, the creditors will very likely still require the major shareholder(s) to sign personal guarantees. This makes the shareholders personally obligated if the corporation fails to pay. Common examples of this are commercial leases of business premises, major equipment and vehicle leases or purchases, franchise agreements, and SBA loans.

As a result, when the business cannot pay its debts, the individual shareholder(s) are usually on the hook for all or most of the debts of the business. The business corporation’s limited liability is trumped by the shareholders’ contractual obligations on the debts.

Ever Worth Filing Bankruptcy for the Business Corporation?

By the time most small businesses close their doors, they have run themselves into the ground and do not have much remaining assets. And often, what little is left is mortgaged, with the assets tied up as collateral, leaving nothing for the corporation’s general creditors. This applies not just to purchases and leases of assets, but also to bank loans which require a blanket lien on all business assets, and commercial premises leases with broad landlord liens.

Without any assets with which to operate, the business dies. Without any assets for creditors to pursue in the business, the debts die with the business, except to the extent the shareholders are personally liable.

But sometimes the business does still have substantial assets when it closes its doors. Assuming the business is in the form of a corporation or partnership and so is eligible to file its own Chapter 7 bankruptcy, doing so may be worthwhile for three reasons:

• A bankruptcy would enable the owners to avoid the hassles of distributing the corporate assets by passing on that task to the bankruptcy trustee.
• There are risks for the owner of a failing business in distributing the final assets of the business, which can result in personal liability for the owner. Filing bankruptcy avoids that risk because the bankruptcy trustee takes care of that responsibility.
• In some situations, a debt owed by the business corporation is also owed by the business’ shareholder. So when that debt is paid through the trustee’s distribution of assets, that reduces or eliminates the shareholder’s obligation on it.

Most of the Time You’re Left Holding the Business’ Debts

Regardless whether your business can or can’t file bankruptcy, and whether or not it ends up doing so, you will likely have to bear the financial fallout personally. By their very nature bankruptcies arising out of closed businesses tend to be more complex than straight consumer bankruptcies. So be sure to find an attorney who is experienced in these kinds of cases.