Chapter 7 Bankruptcy Can Help Corporations And LLCs Go Out Of Business In An Orderly Manner
Richard Fonfrias, J.D.
Chicago’s Financial Rescue & Bankruptcy Lawyer
Fonfrias Law Group, LLC
The Fundamentals Of Corporations & LLCs
Filing a Chapter 7 bankruptcy for a corporation or LLC is different from filing one for a person in three ways: (1) both a corporation and an LLC are separate legal entities, (2) creditors have an increased need to be protected when corporations and LLCs close, and (3) creditors have the ability to transfer the company’s liability to an individual.
Setting Up A Corporation Or LLC
All it takes to form a corporation or LLC is to file paperwork with the secretary of state and pay registration fees. Then the company simply runs as a unique and separate legal entity. The company owns its own assets and is responsible for paying its bills.
Since corporations and LLCs are separate legal entities, no person owns them outright. Instead, people own shares of a corporation and an LLC member holds an ownership interest as described in the company’s operating agreement. Each form of ownership interest means that owner is entitled to part of the company’s value and profit.
For Example: When a corporation’s shareholder – or an LLC’s member – files a personal bankruptcy, the person lists only the value of the corporate shares or LLC ownership interest he owns. The bankruptcy trustee can sell only the person’s interest in the company, not the company itself, unless the person is the company’s sole owner. Corporations and LLCs work well for people who want to start a business without risking their personal assets.
Shutting Down A Corporation Or LLC
When closing a corporation or LLC, the corporate officer or the LLC’s managing member must liquidate the assets and dispense funds to the creditors. Then he must also file notice of closure with the secretary of state. Not following these steps could subject owners to legal liability.
These requirements discourage insiders from taking assets because creditors cannot collect on accounts owed to them after the business shuts down.
How Chapter 7 Works For Corporations & LLCs
When a Chapter 7 business bankruptcy is filed, it also closes the corporation or LLC. The bankruptcy trustee sells all of company’s assets and disperses the proceeds to the creditors based on the rules and priorities in bankruptcy laws.
The creditors do not receive a debt discharge because the company is not operational and has no remaining assets of value.
In addition, by leaving any remaining debt in place, a creditor can pursue actions against individuals who may have guaranteed payment, committed fraud, or taken any other action that warrants creditor litigation.
Chapter 7 Advantages For Corporations & LLCs
Closing a business in bankruptcy permits a high level of transparency. It’s easier for creditors to see that the business closure occurred as required by law.
Creditors often suspect that an officer or member might be diverting funds into their pockets rather than paying creditors. But in a Chapter 7 liquidation, the bankruptcy trustee sells the company’s assets and pays its obligations in a court-supervised proceeding.
Chapter 7 Disadvantages For Corporations & LLCs
As soon as you file Chapter 7, control of the company goes to the bankruptcy trustee. It’s his duty to take over the business assets and decide whether the creditors’ interests are best served by selling the business or selling the individual assets.
If you are legally liable for any of the business’s debt, then you might be in for a big surprise. Because after the bankruptcy, the amount of debt that remains could be greater than if you sold the individual assets yourself. Here’s why:
1. You might be able to sell the business or assets at a higher price. Bankruptcy buyers expect a low-price deal.
2. The trustee receives a percentage of the sales price, which lowers the amount that will go to pay creditors.
3.You won’t be able to negotiate a lower figure with creditors than what is owed. The trustee will pay exactly the amount owed on the debt.
Disadvantage: After the trustee pays on the debt, any balance will remain payable. This means you could be left owing more than if you had negotiated with creditors and taken the time to sell the assets on your own.
Disadvantage: A bankruptcy filing opens the business books so a disgruntled party can air seemingly endless complaints about how the company’s finances were handled. Many disputes of this sort can shift the debt liability from the company to an individual.
How A Person Could Be Legally Liable For Corporate Or LLC Debts
While corporations and LLCs are legally responsible for their own debts, it’s entirely possible for an individual to find himself liable for his company’s obligations. Here are a few scenarios in which one person could find himself on the hook:
1. Alter Ego Claims. A creditor can pursue a person’s assets if it can show that the corporation or LLC was merely a sham or the alter ego of the shareholder. This type of claim means the creditor must file a lawsuit to pierce the corporate veil that protects the shareholder’s personal assets from the business’s creditors. Winning the lawsuit allows the creditor to collect from the individual’s personal assets.
2. Fraud Claims. Most types of fraud involve an effort to conceal money from creditors. If creditors can prove the claim, the person must repay the creditors and may face criminal penalties as well.
3. Trust Fund Taxes. An officer or managing member can be held legally responsible for “trust fund taxes:, which are taxes that are withheld from an employee’s income.
4. Personal Guarantees. When a business lacks assets or a profit history, it’s common for an individual to sign a personal guarantee to be responsible for business debts or by pledging personal assets as collateral.
How A Personal Bankruptcy Can Discharge Or Pay A Business Debt
If you signed a personal guarantee for a business loan, filing a personal bankruptcy could be to your advantage.
Often, the best solution is for you to file a Chapter 7 bankruptcy. In most cases, an individual can get rid of a personal guarantee for business debts, other than student loans, in a Chapter 7 bankruptcy.
What’s more, if most of your debt is business-related, you may qualify even if your income surpasses Chapter 7 limitations. When you have more business debt than consumer debt, you can avoid both the Chapter 7 income requirements and the means test. So even with a sizeable income, you can often erase a personal guarantee in Chapter 7 bankruptcy.
But if you can’t avoid the means test, and if you don’t qualify for Chapter 7, you can still fall back on Chapter 13 bankruptcy and pay off the personal guarantee over five years. And while Chapter 7 won’t erase liability for most taxes and fraud, you can pay off these debts with a Chapter 13 five-year repayment plan.