Corporate Bankruptcy – Protecting the Owners Or the Business?

For purposes of this article, usage of the word corporation also includes partnerships and LLCs.

Many times, corporate owners looking into bankruptcy aren’t actually concerned with the effect on the corporation, but on themselves personally. This article examines the fallacies and misconceptions held by many such corporate owners.

There are two bankruptcy choices for a corporation: Chapter 11 or Chapter 7.

Chapter 11 allows the business of the corporation to continue and reorganize the debts by proposing a repayment plan to creditors. Creditors get to vote for or against the plan. A full treatment of Chapter 11is beyond the scope of this article.

Chapter 7 is a liquidation of the corporation’s assets. When a Chapter 7 case is filed a corporation must stop doing business, if it is still operating. A Trustee is appointed to sell the corporate assets and disburse the proceeds in accordance with statute to creditors. It is very important to understand that corporations do NOT receive a discharge of debts in a Chapter 7 case.

Many corporate owners are confused about this basic truth. The confusion apparently stems from the fact that many business owners do not understand that a corporation is a separate legal entity (which is, presumably, why it was formed to begin with). Whether or not a corporation files bankruptcy has nothing to do with any personal obligation the owners or officers of the corporation may have. For example, if the owner of a corporation signed personal guarantees on certain corporate debts, or has personal tax liability for corporate tax obligations (such as employee payroll trust fund taxes), that obligation does not disappear unless and until those debts are paid. So unless there are enough assets available in the corporation to pay all those debts, the owner will still be obligated on those debts for which they are personally liable regardless of what the corporation does. Filing bankruptcy for the corporation does not affect their individual liability either way.

So, in short, whether or not a corporation receives a discharge of debts is a big “who cares?” because it simply doesn’t affect anything. If a corporation is going out of business, it simply doesn’t matter whether the debts are discharged or not because the corporation’s creditors will just sue the corporation and recover against whatever assets of the corporation are available and that does not affect the principals of the corporation.

Most of the time, these corporate owners are actually looking to do is file a bankruptcy for themselves personally. In such cases, they should consult with a bankruptcy attorney about an individual bankruptcy case.

But, there are times where filing a Chapter 7 case for a corporation is beneficial such as where the corporation has assets and wants to stop doing business. In such a case, having an independent Trustee appointed to sell and disburse assets to creditors can eliminate that responsibility for the owner(s) of the corporation and releases them from liability for not having properly disbursed corporate assets and winding up the corporation properly. this satisfies the fiduciary duty all corporate officers have to the corporation’s creditors when a corporation becomes insolvent.

Another benefit of filing a Chapter 7 for a corporation is that it puts all the corporation’s creditors on notice that the business is terminating and whatever assets may be available will be distributed through the bankruptcy, and that will be all. Thus, there would be no reason for the creditors to sue the corporation post-bankruptcy, whereas if a bankruptcy is not filed, the owner of the corporation may have to continually appear in court to inform the judgment creditors that the corporation is no longer operating and has no assets.

It can help when you’re consulting with a bankruptcy attorney to understand the basic concepts above.