Business Bankruptcy FAQs

Q: Can a business be forced into bankruptcy?

  • A: Yes. If enough is at stake, creditors can start an involuntary bankruptcy action against a business. This doesn't happen too often, but it does happen when creditors are concerned that a business is squandering or misappropriating assets that should otherwise go to pay the debts owed to the creditors.

Q: Can a business get a discharge?

As a sole proprietor, you should keep in mind, though, that a bankruptcy filing must include all of the business'debts, regardless of how or why they were incurred. So, it may be difficult, even impossible, to treat business debts separately from your personal finances. The assets of a sole proprietorship, like business equipment,are property of the bankruptcy estate.That means the assets may be sold to pay off your debts, unless they're claimed exempt or abandoned by the trustee in a Chapter 7 bankruptcy.

But it may be possible to classify business debts separately and pay them in full in a Chapter 13 bankruptcy. This may be a good option for you if,for example, the business wants to continue using vendors during and after the bankruptcy.

Q: Can a debtor give special treatment to certain creditors?

  • A: As a general rule, no. In any bankruptcy, the fair treatment of all creditors is a main goal. Practically any transfer of business property or assets during the 90 days before bankruptcy is filed may be avoided or set aside by the bankruptcy trustee. That includes making payments to creditors.

Also, transfers to insiders (relatives, general partners and directors or officers of the business, for instance) made up to one year before filing can be avoided. And, the laws in your state may give the trustee even more time to avoid some transfers.

It's important to talk to your attorney about all transfers, payments, etc. made by the business to make sure it's the right time to file for bankruptcy.

Q: Can all types of debt be discharged?

  • A: No. Although the debts that can't be discharged vary slightly between the different chapters of bankruptcy, you generally can't discharge debts:
    • For taxes owed to local, state or federal agencies
    • For money, property, services, or an extension, renewal or refinancing of credit, when it was obtained fraudulently
    • Not listed or scheduled in the bankruptcy paperwork
    • The bankruptcy-debtor waived discharge
    • Owed to a spouse, former spouse or child of the bankruptcy-debtor, for spousal alimony or child support
    • Owed for willful and malicious injury by the bankruptcy-debtor to another person or property owned by another
    • For government sponsored educational loans, unless it can be shown repayment will cause an undue hardship
    • For death or personal injury caused by the bankruptcy-debtor's drunk driving or from driving while under the influence of drugs, or other substance
    • Incurred after the bankruptcy was filed

Q: If they can't pay their creditors, how do people afford bankruptcy lawyers?

  • A: Bankruptcy lawyers usually insist on being paid up front. When people know that filing bankruptcy is inevitable, they can plan ahead to pay their lawyer. This usually involves paying the lawyer with money that may have gone to the company's creditors.

The logic is that, if someone is going to file bankruptcy anyway, it's better to reallocate the resources to pay for good legal representation rather than continue to pay on debts that may be discharged or restructured in the bankruptcy.

Keep in mind, too, bankruptcy lawyers usually aren't considered "creditors" of the bankruptcy-debtors they represent, so paying them upfront doesn't raise the problem of favoring one creditor over another.

Q: Isn't it true that someone can only file for bankruptcy once every seven years?

  • A: No. This is a common mistake made by people and businesses looking into bankruptcy. As general rules, you can't get a discharge through:
  • Chapter 7 or Chapter 11, when the case is filed within 8 years after you received a discharge in a Chapter 7 or 11 bankruptcy
  • Chapter 7 or Chapter 11, when the case is filed within 6 years after you received a discharge in a Chapter 12 or Chapter 13
  • Chapter 13, when the case is filed within 4 years after you received a discharge in a Chapter 7, 11 or 12 bankruptcy
  • Chapter 13, when the case is filed within 2 years after you filed a Chapter 13 bankruptcy

There are strategies you can discuss with your lawyer. For example, you can file a Chapter 7 to discharge those debts that are dischargeable and file a subsequent Chapter 13 to repay those debts that were not discharged in Chapter 7.

Q: What happens if a debtor or a creditor doesn't follow the bankruptcy rules?

  • A: The bankruptcy rules are very complicated. If a bankruptcy-debtor doesn't follow them, or isn't truthful with the bankruptcy court, the court may deny a discharge. Debtors have to be very careful to account for everything and to follow the bankruptcy rules.

In the alternative, a bankruptcy court may simply dismiss a bankruptcy, meaning the debtor is no longer protected by the bankruptcy laws. A debtor could even be prosecuted criminally.

Creditors are not immune, either. They may face similar penalties if, for example, they scheme with the debtor to hide assets. A creditor can also get into big trouble with the bankruptcy court for violating the automatic stay.

Q: What happens to my corporation if I file personal bankruptcy?

  • A: Since the corporation is a legal entity different and distinct from its shareholders, the bankruptcy of a stockholder doesn't affect the corporation. But the bankrupt shareholder's shares in the corporation are an asset of the debtor's bankruptcy estate. So, they may be used to pay the debtor's creditors.

A corporate bankruptcy shouldn't directly affect the shareholders. If the officers or shareholders are personally liable for the debts of the business, the automatic stay in the corporation's case doesn't prevent creditors from trying to collect from others who may be liable.

Stockholders don't have to be notified of a Chapter 7 filing because they usually don't receive anything in return for their investment. If creditors are paid in full, the court will notify the stockholders and give them a chance to file claims to whatever is left over.

It makes no difference if you've made an "S" election for your corporation. Such an election is a matter of tax law. For purposes of the bankruptcy laws, an "S" corporation is treated no differently than a "C" corporation. But any taxable income generated by an "S" corporation after bankruptcy may still be taxable to the shareholders, as the corporation isn't a taxpaying entity.

Q: What's "bankruptcy" and how does it affect business?

  • A: While technical definitions of bankruptcy can vary, the term refers to a situation where an individual or a business has more debts or liabilities than assets and usually can't meet their financial obligations as they become due.

Virtually anyone or any type of business entity can start a bankruptcy proceeding by filing a petition in federal bankruptcy court. The person who files the petition is called the bankruptcy debtor.

The filing of a bankruptcy petition affects all creditors of the debtor. There are many different categories of creditors, including:

  • Secured creditors - usually those with a lien on a debtor's property
  • Unsecured creditors - usually vendors, credit card companies and anyone else who doesn't have a security interest in any of the debtor's property
  • Judgment creditors - usually those creditors who have sued and obtained a judgment against the debtor before the bankruptcy was filed
  • Creditors with super priority claims - they have higher priority over other creditors because of special rules or proceedings within the bankruptcy
  • Creditors with administrative claims - usually creditors such as accountants or lawyers with claims that are given priority because of their having assisted in the bankruptcy in some manner
  • Post-petition creditors - those who extended credit to the debtor after the bankruptcy has been filed. Bankruptcy generally covers only pre-petition debts, or those that existed at the time the petition was filed

Inevitably, every business is going to run into situations where customers file bankruptcy. Businesses also end up filing bankruptcy, as well.

Q: What's the effect of filing a bankruptcy petition?

  • A: The filing of a bankruptcy petition is a lot like filing a lawsuit in the sense that the act of filing simply starts a legal proceeding without any guarantees of the outcome. The debtor must go through a statutory process, with creditors and other third parties given the opportunity to challenge and object to the discharge or restructuring of the debts owed to them.

Unlike any other type of legal proceeding, though, the filing of a bankruptcy petition immediately gives rise to an automatic stay. It stops creditors from taking any further action to try to collect their debts unless or until the bankruptcy court gives them permission to do so. decides to the contrary. The stay is meant to give debtors temporary relief from their financial problems, giving them the opportunity to figure out how to deal with them.

The automatic stay is only temporary, and there are any number of ways a creditor can get relief from the bankruptcy court to proceed with trying to collect its debt. One common way is to file a petition or motion with the court, asking for relief from the automatic stay.

In the case of a secured creditor, a court will look to see if the creditor is adequately protected. For example, a creditor with a lien on real property may still be adequately protected if there's enough equity and/or the debtor starts making "post-petition" payments again after the filing of the bankruptcy. If there isn't adequate protection, a creditor may be given permission to proceed with foreclosure or other remedies.

Q: What kinds of bankruptcies are there?

  • A: There are four kinds of bankruptcy proceedings. They're commonly known by the different chapters of the federal bankruptcy code that covers them:

Chapter 7

Chapter 7 is the most common type of bankruptcy proceeding. Individuals, married couples, corporations and partnerships can use Chapter 7. In most of these cases, all or most of your debts are discharged or extinguished.

A bankruptcy trustee is appointed to the case and controls all of your assets, and may sell anything that isn't exempt to pay your debts.

Chapter 11

Chapter 11 is a reorganization proceeding, usually used by corporations or partnerships. Here, a business tries to reorganize its outstanding debts and continue business operations.

The debtor, called the debtor-in-possession, prepares a reorganization plan. It sets out which debts will be paid off, how much and when. It must be approved by the court and the creditors. Generally, the plan must provide for paying creditors at least as much as they would have been entitled to be paid in a Chapter 7 liquidation proceeding.

Through Chapter 11, a business can reduce or eliminate debt and try to make itself profitable again, paying creditors out of future income. However, it isn't easy to salvage a business through Chapter 11, and many cases end up converting to a Chapter 7.

Chapter 12

This is a reorganization bankruptcy for family farmers. It's modeled after Chapter 13. Framer-debtors keep their properties and pay creditors out of future income.

Chapter 13

Chapter 13 is a repayment plan for individuals only. Debtors keep all or most of their belongings in exchange for making regular payments to their creditors over a period of time, usually 3 or 5 years.

Repayments are made according to a repayment plan made out by the debtor. The plan must approved by the court and the creditors.

As a business owner, it's critical that you and your attorney discuss which type of bankruptcy is best for you and your business.

Q: When should a business file for bankruptcy?

  • A: This isn't an easy decision, and a business owner should first exhaust all other options. There are also different types of bankruptcy proceedings, so the decision may not be as simple as you think. It's a good idea to get financial and legal advice before taking any action.

As a business owner, you may want to file bankruptcy if there's a black cloud of credit problems hanging over your head that just won't go away. In these situations, the relief of filing bankruptcy will usually outweigh the inevitable drawbacks from doing so, such as loss of the business, hurting your credit history and embarrassment.

In a business setting, though, there may not be quite the stigma to filing bankruptcy and it can actually be an effective tool to save a business. In a Chapter 11 proceeding, for example, you can sometimes restructure or consolidate debts and come out of the bankruptcy with a fresh start.

Most publicly-held companies file under Chapter 11 rather than Chapter 7 because they can still run their business and control the bankruptcy process. Chapter 11 is a way to rehabilitate the business. Sometimes the plan returns the business to profitability; other times it ends up liquidating.

In most instances, creditors would rather that a business not file for bankruptcy since they may then get nothing. But creditors are usually of the mindset that none of them is going to accept a compromise on a debt unless they all do. The threat of filing bankruptcy is sometimes just the leverage a business needs to hold creditors at bay until the business turns around.

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