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Corporations in Bankruptcy

Orange County, New York Attorneys Discuss Corporations in Bankruptcy

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:

  1. To protect the shareholders from frivolous lawsuits brought by the corporation’s creditors. Creditors starting a lawsuit against a corporation whereby they seek to recover and collect on a purely corporate debt will frequently name as defendants in the Complaint the individual shareholders of the corporation as well, hoping that said shareholders will ignore the lawsuit, confident that the debt being sued upon is owed by the corporation alone. However, if the individual shareholder fails to respond (i.e. serve and file an Answer) the creditor will obtain a Default Judgment against said individual and thereafter can try to collect the Judgment from the individual’s assets. It has been this firm’s experience that once a corporate bankruptcy is filed, creditors of the corporation are much less likely to start lawsuits against the individual shareholders when they know that said shareholders have no legal obligation to repay the corporate debt in question.
  2. When the corporation has debts that the individual shareholder is personally liable to pay, such as “trust fund taxes” (i.e. sales tax or employee withholding), and general unsecured creditors are threatening to seize corporate assets to satisfy their particular claims. In such an instance, the shareholder would much prefer to have the corporate assets used to pay debts for which he has individual liability. A Chapter 7 bankruptcy filing can achieve this goal, as the Chapter 7 Trustee would liquidate the assets in question and make payment to creditors according to the priority schedule set forth in the Bankruptcy Code. This would benefit the shareholder because recently incurred tax obligations get repaid through a bankruptcy distribution before general unsecured creditors do,
  3. When the corporate officers and shareholders do not want to go through the time, trouble and expense of winding down and dissolving the corporation, either informally or pursuant to State law. Upon a Chapter 7 filing, all of the creditors are “under one roof”, and the Trustee can liquidate the corporate assets while enjoying the benefits and protections afforded by the automatic stay. This can result in more orderly and inexpensive (to the debtor) liquidation process.

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:

  1. The corporation can usually obtain a better price for its assets than a Chapter 7 Trustee, given its contacts in the industry and familiarity with the market.
  2. The corporation can control who gets paid after its assets are liquidated, and can earmark funds for the payment of “trust fund taxes” and other debts upon which the shareholders may have personally liability, such as leases, etc.
  3. The corporation is free to repay legitimate debts owed to its shareholders and other insiders, since the concept of a preferential payment is solely a creation of the Bankruptcy Code. If you are not in Bankruptcy, there is no such thing as a preference.

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:

  1. Do not sell an asset that is someone’s collateral (i.e. there is a lien on it) unless the lien holder (1) is aware of what you are doing and consents to it, and (2) receives the full sale proceeds, or some other agreed upon amount.
  2. Do not sell assets that are leased as such assets belong to the leasing company and not to the business.
  3. Do not sell assets for less than fair market value, and certainly do not give away valuable business assets. Such activities will usually come back to haunt you, and should be avoided whenever possible. Be sure that at least “liquidation value” is obtained for each asset sold, and maintain records (i.e. appraisals, etc.) that will help establish the propriety of the sale price obtained for each asset sold.

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.

Corporate Bankruptcy Does Not Erase Personal Liability on Certain Corporate Debt

A primary reason people incorporate business enterprises Is to avoid personal liability on business debts.  However, there are several situations where they can still find themselves liable or corporate debts, including the following:

  • Personal guarantees: Lenders frequently will not extend financing to a corporation without shareholders signing a personal guarantee.  A corporate Chapter 7 bankruptcy filing DOES NOT get the shareholder off the hook from any personal guarantee that may have been signed.
  • Trust fund taxes: Responsible Financial Parties (“RFP’s), usually officers, can be held liable for “trust fund taxes”, such as sales tax or taxes withheld from an employee’s income.
  • Alter-ego claims: A creditor can go after the personal assets of an individual shareholder if they “pierce the corporate veil” and prove the corporation was a “sham” or an “alter-ego” of the shareholder.  To do this a lawsuit seeking such relief must be brought by the creditor and successfully prosecuted in Bankruptcy Court.
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