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  • Writer's pictureBrett Weiss

When Should a Busisness File for Chapter 7?

As I discuss in my blog, "Business Chapter 7? Probably Not," in the vast majority of cases, a business will not want to file a voluntary Chapter 7 because it can't receive a Chapter 7 discharge. So if it can't get a discharge, what's the sense in filing?

There are three primary circumstances in which it might make sense to at least look at a Chapter 7 for a business.

The first situation is designed to protect an owner of the business who personally guaranteed some of the business debt. If the business simply closes, creditors holding guaranteed debt can sue the guarantor, and, if it gets a judgment, can place liens on assets, attach wages and bank accounts, and take other collection actions. However, if the business paid creditors a substantial amount of money during the 90 days before the bankruptcy is filed, there were a transfer to an "insider" -- a director, officer, person in control of the business, or a relative of such a person -- of the debtor during the year before the bankruptcy is filed, or there were a "fraudulent conveyance," within the filing state's statute of limitations (at least two years), the bankruptcy trustee could sue to recover these transfers, take a commission, and distribute the rest to creditors, thus lowering the amount to be paid under the guarantee.

The second circumstance is where withholding taxes weren't paid, making the "responsible party" -- usually the owner, director, bookkeeper, treasurer, or whomever had the power to determine who would get paid -- personally liable for the unpaid taxes. In addition to recovering payments as described above, the bankruptcy trustee can sell business assets. After taking a commission, the remaining funds are distributed to creditors in accordance with the Bankruptcy Code's "priorities"...and the IRS is close to the top of the list. This makes sure that assets go towards the IRS, and thus towards the "responsible party's" personal liability, instead of to general unsecured creditors.

The third situation is where there assets but also many claimants against the business. Think a bridal gown store, a store that took lots of down payments, or some business that has many (usually very angry) customers and not enough money to go around. Filing a Chapter 7 in these circumstances can give a neutral third party the legal authority to liquidate the business' assets and make distributions fairly.

Does this work? Not always. There must be either significant assets to be liquidated or recoverable funds, and there are risks that the bankruptcy trustee will go after the owners or directors to try to recover these funds. But in limited circumstances, this can be a valuable tool when winding up a business.

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