Unlike sole proprietorships, shareholders in a corporation are separate legal entities from their businesses. Consequently, a corporation can file a Chapter 7 (but not a Chapter 13) bankruptcy in its own name, but it is not entitled to receive a Chapter 7 Discharge. Despite this, there are a few instances and circumstances where a corporate Chapter 7 bankruptcy filing can be appropriate and advisable, including the following:
There are some distinct benefits, which can be realized by shareholders if they take things into their own hands, without resorting to bankruptcy, and liquidate a corporation’s assets and repay its debts on their own, such as:
Any small business attempting a “do-it-yourself” liquidation, be it a corporation or a DBA, should be mindful of a few caveats that should be honored:
Although a corporation and its shareholders are separate legal entities, the bankruptcy filing of one entity can, in some circumstances, have profound consequences for the other.
If an individual files a Chapter 7 bankruptcy at a time when he owns shares of stock in a corporation that is operating a business, said corporate stock is an asset of the individual’s bankruptcy estate that can be liquidated by the Trustee. The stock can be sold by the Trustee, provided he can find a buyer. Although stock in a “Mom and Pop” usually has limited value, if there is an angry former spouse or business associate out there in the bushes this unfriendly person may surface at just the wrong time and make an “offer to purchase” to the Trustee. While the Trustee will give the debtor an opportunity to top the offer received from the “unfriendly”, the debtor may find himself in an unexpected bidding war that he could well lose, given that one’s financial resources are usually at their low point when they file for bankruptcy. In addition, if the debtor is the sole shareholder (and in some instances even just a majority shareholder) of a corporation which has a significant net worth (i.e. the value of the corporate assets greatly exceeds the amount of corporate debt), the Chapter 7 Trustee can “step into the shoes” of said sole shareholder/debtor and file a corporate Chapter 7 bankruptcy on behalf of the corporation, with the hope being that after the Trustee in the corporate case liquidates all corporate assets and pays off all corporate debts there will be surplus funds that will spill over to the individual debtor’s case, thereby creating funds for a distribution in the individual case. The above scenario is rather complicated and cumbersome and does not frequently occur, but it can totally ruin your day if it happens in your case.
The bankruptcy filing of a corporation does not necessarily affect its shareholders, except where the corporation made preferential payments to the shareholder or fraudulently transferred assets to the shareholder. The Chapter 7 Trustee should try to set aside these preferential payments and fraudulent transfers and recover their value from the recipients thereof. In addition, consequences can flow to the individual shareholder if the corporation has elected to receive Sub-Chapter S tax treatment (hereafter referred to as an S Corporation). The income generated by a Trustee’s sale of the assets of an S Corporation may be taxable to the shareholders and not the bankruptcy estate, since an S Corporation is not a tax paying entity and the bankruptcy estate generally assumes the taxpayer status of the debtor.
Unlike a sole proprietorship, once a corporation files a Chapter 7 bankruptcy it must discontinue its business operations immediately. Its shareholders must be prepared for this and willing to accept it, so sometimes the timing of the corporate Chapter 7 case can be critical. In addition, all small businesses (i.e. corporations and DBAs) must be prepared to turn over all of their business books and records to the Chapter 7 Trustee upon demand. If the books, records and recent financial dealings of your business will not withstand strict scrutiny, then bankruptcy might not be the place for you.