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

If your business has failed or is about to, it does NOT likely need a bankruptcy. But YOU personally might.

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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.

The business usually doesn’t need a bankruptcy because it doesn’t have enough assets to justify going through a formal bankruptcy distribution procedure. Instead, the business dies and its debts fall on the owner, who then needs to protect his or her assets and future income.

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Business Corporation Is No Shield for Owners of Small Businesses

When a small business owner sets up his or her business as a corporation, one reason for this is because in theory only the corporation is liable for its own debts, the debts of the business. The investor-owners of the business are not liable for those business debts. That is at the heart of what a corporation is—a legal structure of limited liability.

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, for at least the larger obligations of the business. 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 either directly liable or through personal guarantees become personally liable on 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. Often the business’ shareholders have by this time spent many years in a very stressful juggling act, so may be very happy to let the business and its assets go to get some peace.
• 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.  

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