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Should My Failing Corporation or LLC File Bankruptcy if I Am Not Filing Personal Bankruptcy?

Jeff Williams, Esq. Aug. 15, 2022

In this article, we are going to discuss each of the following areas:

I. Small Business Bankruptcy In General
II. Filing Chapter 7 Bankruptcy for Corporations and LLC’s
III. Reasons to File A Chapter 7 for Your Small Business Entity
IV. Reasons Not to File A Chapter 7 for Your Small Business Entity
V. Should You Consider Filing Chapter 11 Bankruptcy for Your Small Business Entity? VI. Summary & Conclusion

Let’s get started:

I. Small Business Bankruptcy In General

Both a Corporation (S- or C-) and an LLC are legally treated as a “separate person” from yourself. Therefore, if the business has a lot of debt, and is not making enough to pay the debts down (or is losing money), you have no personal liability for any of the debts unless you signed a personal guarantee. However, the Feds will go after you personally for any unpaid payroll withholding taxes, and the State will go after you personally for any unpaid sales taxes.

Whether your small business entity should be bankrupted or not depends on several factors. Among the factors to be considered are:

  • Do you have the time, energy, and desire to continue the business?

  • Are there any significant assets (tools, inventory, vehicles, buildings, etc.)?

  • What is the net worth of the entity, when debts are subtracted from assets? (You need an accurate current Balance Sheet to determine this.)

  • How much profit or loss did your company generate during (1) the six calendar months prior to your bankruptcy filing and (2) for the year-to-date when you file?

  • Do you own all the stock or membership interest? If not, who else does, and how much?

  • Are any Federal withholding (payroll) taxes due? Are any State sales taxes due?

  • Are there any unpaid salaries due?

Another matter to be decided in making this decision is, are your personal finances and those of your corporation or LLC (hereafter, called “entity”) entirely separate, or intermingled? Although they are supposed to be entirely separated, many (if not most) small businessmen intermingle them to some extent, sometimes hopelessly. For example, perhaps some months there isn’t enough money in your personal account to make a required house or car payment, so you write a check from your business account to cover it. Or, the business entity has some bills coming up, so you cover them by making payments using your personal charge cards. Intermingling like this can make it very difficult, or impossible, to figure who owes what. It can also invite a detailed tax audit of both yourself and the entity.

Whether intermingling is a problem or not, if your business entity is way behind on bills with no chance of catching up, it may or may not make sense to also file bankruptcy for the entity.

One thing that even some bankruptcy lawyers don’t know (in our experience) is that a corporation or LLC filing Chapter 7 bankruptcy is not permitted to discharge its debts in bankruptcy! Section 727(a)(1) of the Bankruptcy Code says, “The court shall grant the debtor a discharge, unless the debtor is not an individual.” Since corporations and LLC’s are separate persons, but are not individuals, they cannot receive a Chapter 7 discharge. After the entity’s bankruptcy is over, creditors can still go after its assets, if any remain.

Note: In making the decision whether or not to file bankruptcy for your small business Corporation or LLC, you must provide the company’s bankruptcy attorney with accurate valuations, including detailed income and expenditure records, profit and loss statements, inventory records, etc.. Even your accountant may not have all this information. A bankruptcy trustee will ask you how you valued your company, and you need to have clear, concise explanations as to how you determined the value of each item to avoid harming your case.

Corporations or LLC’s can file either Chapter 7 bankruptcy or Chapter 11 bankruptcy, but not Chapter 13 bankruptcy. Although they cannot discharge their debts in a Chapter 7, they can under certain circumstances in a Chapter 11. We will say more about Chapter 11 later. For the present, suffice it to say that very few small corporations or LLC’s are good candidates for a Chapter 11.

II. Filing Chapter 7 Bankruptcy for Corporations and LLC’s

Chapter 7 is for the liquidation of a failed entity, not for reorganization or continued operation, as in Chapter 11. Many times, when the owner of a small business corporation or LLC concludes that their entity is losing money and there are no assets in the entity, they just stop operating it, and do not bother to file bankruptcy for the corporation, to save money. (They allow the corporate status to lapse with the State by not renewing the annual registration; eventually, usually two years or so after the entity stops paying annual registration fees, the State terminates the existence of the entity by Administrative Dissolution.)

If there are no assets, in many cases this makes sense, as entity debts not personally guaranteed by the owner cannot be charged to him/her. However, if the owner has personally guaranteed the entity’s loans or lines of credit, the owner can be sued for any default. In this case, if the debts are significant, the owner may wish to file personal bankruptcy, whether or not they file bankruptcy for the entity.

There are several situations in which it makes good sense to file a Chapter 7 for the entity, even though no discharge is available. Let us now consider these.

III. Reasons to File A Chapter 7 for Your Small Business Entity

1. If your entity has any assets and owes employment (payroll withholding) taxes or sales taxes, you do not want regular business creditors to get the assets first by filing collection suits. If they do, the Federal government will later go after you personally for unpaid payroll taxes, and the State will go after you personally for unpaid sales taxes. By filing bankruptcy for the entity, the Trustee will pay these more important claims first, in order of priority under the Bankruptcy Code, before paying any remaining assets to less important creditors. Also, the Trustee will give priority treatment to any unpaid wages which were earned by any employees of the entity (possibly including you) during the 180 days before filing bankruptcy (or cessation of the business, whichever came first), up to $10,000 per employee.

2. If there are considerable assets (such as product inventory, vehicles, tools, one or more buildings, etc.), but the business is not going to continue, the owner may wish to hand off the duties of liquidation and distribution of assets to a bankruptcy trustee. This way there is no question that the creditors have been fairly treated under the bankruptcy code, and that they have received all that is available for distribution, even if it is only pennies on the dollar.

3. Sometimes if the corporation or LLC defaults on its debt and does not declare bankruptcy, one or more of the creditors may file suit in hopes of collecting the debt, often naming the owner/shareholders as well in the suit. Even if only the entity is named, and the owner ignores the suit, when the court enters a default judgment, the creditor(s) may well require post-judgment interrogatories to determine whether there are any assets to attach. If the owner or former president/director/manager does not produce these, they could be fined or jailed for contempt of court.

Additionally, the State of Georgia no longer allows an officer or owner of an entity to answer for it in court, but requires a licensed attorney to do so. Paying an attorney to do this, and/or paying an attorney to answer for you if they also sue you personally, often costs more than simply filing a Chapter 7 bankruptcy for your entity. Besides, by filing a Chapter 7 for your entity, you make a claim that there are no assets to distribute more credible, and a matter of public record.

However, filing a Chapter 7 for your corporation or LLC can conceivably cause unnecessary problems for an owner/ shareholder /membership interest holder. Here are three of them:

IV. Reasons Not to File A Chapter 7 for Your Small Business Entity

1. The bankruptcy Trustee is obligated by his position to try to find a way to pay creditors. Besides liquidating any assets of the corporation, he may look for other sources of cash. If the entity’s financial affairs were intermingled with those of the owner(s)/shareholder(s)/membership interest holder(s), as described above, the Trustee may choose to seek to reimburse creditors by suing the owner(s)/ shareholder(s)/membership interest holder(s) and piercing the corporate veil.

2. If the small business entity was undercapitalized, as is the case with most small business entities, there is a risk that the Trustee would seek to hold the owner(s)/shareholder(s)/membership interest holder(s) liable for all the debts of the corporation.

3. The Trustee could also sue to collect loans made by the small business entity to the owner(s)/shareholder(s)/membership interest holder(s), and he could also sue to recover loan payments made to them in repayment for loans they made to the entity in the year or more prior to bankruptcy. Before deciding whether to file a bankruptcy for your corporation or LLC, you should consider all these factors with a good bankruptcy attorney.

V. Should You Consider Filing Chapter 11 Bankruptcy for Your Small Business Entity?

Chapter 11 bankruptcy is sometimes considered as a possible solution by owners of small corporations or LLC’s. Chapter 11 is primarily meant for reorganizing the financial affairs of large and small corporations, partnerships, and LLC’s, to enable the business to continue to operate and hopefully become profitable when it finds that its debts are more than its income. If the business could prosper if only it wasn’t servicing old, non-recurring debt, or if could prosper if it could shed non- critical equipment or premises leases, Chapter 11 may be the answer.

However, Chapter 11 is much more complicated and expensive than Chapter 7 or Chapter 13. Just the filing fee alone to start a new Chapter 11 proceeding is $1,213.00; and a typical cost for legal fees might easily be $10,000 or $20,000 the first year alone. The time period is variable; it could easily be longer than five years, if necessary. There are a lot of reports required for taxes, insurance, operations, and bank accounts. But with Chapter 11 you can get out of any leases for offices or equipment you do not really need, and you can force secured creditors (such as mortgage holders of an office building or factory you are buying, or loans with which you bought vehicles your business needs) to re-write the loans down to the actual cash value of the items being paid for, possibly with other improvements in the terms.

The problem with small business Chapter 11 cases is that they fail very often (that is, they are dismissed by the Court, or forcibly converted to a Chapter 7 by the Court). In fact, it is the opinion of many good bankruptcy attorneys that most small-business Chapter 11 cases fail. The corporation or LLC may not be able to keep the company running without further losses, or may be unable to keep up with the reporting requirements and expenses of the Chapter 11, and consequently fail. The key to avoiding failure is limiting Chapter 11 filings to cases where a Chapter 11 is really called for and could work, combined with careful planning before filing. Even when Chapter 11 is appropriate, cases most likely to fail are the ones filed on an emergency basis, with inadequate accounting or planning as to the company’s true prospects for success.

The main purpose of Chapter 11 is to allow time to reorganize the business to make it successful (or, in the alternative, to allow for orderly, fair liquidation). If the business is not making money now, why not? Is there any evidence or reason this is likely to change? Will layoffs or trimming excess expenses enable the core business to succeed? Was the difficulty due to embezzlement or mismanagement by an employee or manager who is now gone from the company? If filing Chapter 11 will allow time and means to make the business profitable in the future, and stop losing money, and if the small business can meet all the other expenses and requirements, then the Chapter 11 might succeed. Filing just to stall creditors may only delay inevitable business failure. Small businesses should not rush into a Chapter 11 on an emergency basis, without careful planning; that may only be a waste of time and a lot of money. First make sure you have accurate, complete accounting, and up-to-date tax returns, so you and your CPA and a good bankruptcy lawyer can determine the true position of your company and the advisability of filing Chapter 11.

WARNING: occasionally certain law firms like to steer their clients towards Chapter 11 when a much cheaper Chapter 7 would have been much more logical, because under Chapter 11, the law firm stands to make tremendously higher fees, perhaps from four to thirty times as much! For a small company, just the legal fees alone can contribute to failure in a Chapter 11. Such firms sometimes advise their clients to file under Chapter 11 knowing that it is unlikely to succeed, and that the case will likely be dismissed or converted to a Chapter 7 by the court, after the law firm has made a lot of money from the client.

Fortunately, most reputable law firms would not do such a thing, but sometimes, this word to the wise may save you a lot of unnecessary expense and trouble. And a law firm is likely giving you good advice to file Chapter 11 if it is a case where Chapter 11 is the only way possible to keep a business going which has a good chance of success. Situations vary; be sure to see a qualified attorney for advice in your particular case.

VI. Summary & Conclusion

Depending on the circumstances, it may or may not make sense to file bankruptcy for a failing small business. If there are significant assets and/or significant unpaid employment or sales taxes, it is much more likely to be a good idea. However, every case is different, and you need to gather the information listed above and sit down with a good bankruptcy lawyer with significant small business experience to discuss your particular situation. Call us for a free consultation.