If Your Business Can File Its Own Bankruptcy, Should It?

Law Office of Robert L. Firth Dec. 28, 2015

Your failed or failing business does NOT likely need to file its own bankruptcy case (separate from your personal one). Here’s why.

No Assets Worth Protecting or Distributing

Most small businesses do not have any reason to file bankruptcy after they fail. That’s because they usually don’t have enough assets to justify going through a formal bankruptcy distribution procedure. So a failed business usually doesn’t need a bankruptcy.

Failed businesses often also don’t benefit from a bankruptcy because there is no discharge (legal write-off) of the businesses’ debts. Instead, when the business dies its debts often fall on the owner(s), who then needs to protect his/her or their assets and future income. In many situations that requires their own personal bankruptcy.

Business Corporation Is No Shield for the Owners/Shareholders

When a small business owner sets up his or her business as a corporation, one reason to do so is so that only the corporation is liable for its own debts. The intent is to have the investor-owners of the business not be liable for those business debts. That is at the heart of the corporation as a legal creation of limited liability.

But in practice it doesn’t work that way, not with small businesses. That’s because:

  • Many businesses, especially at the beginning and then early in their life, cannot get any credit at all. So they have to be financed entirely through their owners’ personal savings and credit. This credit tends to include personal credit cards, second mortgages on homes, vehicle loans, and personal loans from family members.

  • For those businesses which do get financing directly in the name of the corporation, the creditors will very likely still require the major shareholder(s) to sign personal guarantees, at least for the larger obligations of the business. This makes the shareholders personally obligated if the corporation fails to pay. Examples where this would likely happen are commercial leases of business premises, major equipment and vehicle leases or purchases, franchise agreements, and SBA loans.

So when the business cannot pay its debts, the individual shareholder(s) is (are) personally liable on all or most of the debts of the business either directly or through personal guarantees.

So the business corporation’s principle of limited liability is defeated in practice by the owners’/shareholders’ personal contractual obligations on the business’ debts.

What Happens in Reality

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 whatever assets exist, they are tied up as collateral or with liens against them. This applies not just to purchases and leases of business assets, but also to bank loans and commercial premises leases, which generally require a blanket lien on all business assets.

This leaves nothing for the corporation’s general creditors, and nothing for a bankruptcy trustee to liquidate for those creditors. 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.

When a Failed Business Corporation Should Consider Filing Bankruptcy

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’ owners have by this time spent many years struggling to preserve a dying business and so may be relieved to let the business go and have its assets distributed by a bankruptcy trustee.

  • There are risks for the owner of a failing business as he or she tries to pay out the final assets of the business. Doing this wrong can result in personal liability for the owner to creditors that weren’t paid or were paid less than others. 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.

The Owner is Left Owing 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. Get legal advice about that as soon as you can. Bankruptcy cases involving closed businesses tend to be more complicated than conventional consumer bankruptcies. So be sure to find an attorney who is experienced with these kinds of cases.