File Chapter 7 for Your Business? Think Twice

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Your business is in trouble and your lawyer advises that you file Chapter 7. Before you pull the trigger, you might want to read this.

When a person successfully goes through the Chapter 7 bankruptcy process, they get a “discharge”. That is a court order that declares them to be officially free of their debts. Any creditor who violates that order can be held accountable.

If a corporation or an LLC files a Chapter 7, it does NOT get a discharge. There is no official proclamation that is freed from its debts. The case simply closes after the bankruptcy trustee has investigated its affairs, collected and sold its assets, and after paying the case costs, making a distribution to creditors of whatever is left. Any creditor who wants to pursue the entity, after the case closes ( or earlier if they get court permission) can do so,

So the question becomes, why would an entity EVER choose to file Chapter 7?

In my opinion, there are only two sets of circumstances where it might make sense.

One is where the company has significant unencumbered ( i.e not collateral for a debt) assets AND the company owes back payroll taxes. Why? Because one or more of the principals of the business are probably personally liable for those type of taxes. In the Chapter 7, the trustee would sell the unencumbered assets and the proceeds would go to priority, or top of the food chain creditors….of which the IRS is the big kahuna…thus minimizing or eliminating the personal exposure. Without the control of the bankruptcy system, lower tier creditors might get their hands on the assets before the IRS.

If there are no personal guaranties by the principals of the business, and there are pending or imminent lawsuits, this is another arena where Chapter 7 might make sense. While the debts will not vaporize ( no discharge, remember?), it is unlikely that a creditor would be dumb enough to continue pursuing the lawsuit---if the company had anything of value, the trustee would already have collected and distributed it. The creditor can simply file a claim in the case and get whatever piece of the pie is its share of the collected asset values. To continue trying to collect from a bankrupt Chapter 7 corporate debtor in a closed case is to joust an empty windmill.

Where the principals have personally guaranteed the business debts, no Chapter 7 filing is going to solve their personal problem, so why bother? There are other ways to bury a terminal business entity.