A partnership is a separate legal entity from its individual members. Consequently, a partnership 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. A partnership Chapter 7 filing in New York can be a very dicey proposition for its general partners, since New York law makes each general partner fully liable for all partnership debts, which can lead to nightmarish results. If the Chapter 7 Trustee’s liquidation of partnership property does not yield sufficient funds to pay all (except for non-recourse debts) unsecured creditors in full, Bankruptcy Code § 723 authorizes the Trustee to recover the deficiency from all general partners (but not limited partners). Accordingly, the personal assets of the general partners can be reached by the partnership Trustee, which can ruin your day in a hurry.
Individual partners can also be impacted by a partnership bankruptcy filing if the partner received preferential payments or fraudulent transfers from the partnership. Bankruptcy Code § 548(b) is particularly tough on fraudulent transfers, declaring fraudulent any transfer of partnership assets to a general partner within two (2) years of the bankruptcy filing if the partnership was insolvent (i.e. defined as partnership debts exceeding the aggregate of (a) the value of partnership assets, and (b) the non-exempt equity that all general partners have in their non- partnership property) at the time of the transfer, or was rendered insolvent by the transfer. Intent by the partnership to defraud is not a required element, and consent of the other partners is immaterial. The clear goal here is to prevent general partners from enhancing their fortune at the expense of the partnership’s creditors, and property so transferred can be recovered by the Chapter 7 Trustee. The Trustee can also pursue fraudulent transfers made to non-partners, but in such cases, the Trustee has a tougher burden of proof, as he must prove either intent to defraud or that the transfer was made for less than reasonably equivalent value.
Under New York law, the creditors of an individual partner cannot collect their debt against specific partnership property. Accordingly, if an individual partner files a Chapter 7 bankruptcy his appointed Chapter 7 Trustee cannot sell specific partnership property. The Trustee does succeed to the debtor’s pre-petition “economic interest” in the partnership, which entitles the bankruptcy estate to receive any profits or income stream, which would flow from debtor’s interest, but the Trustee cannot participate in any partnership management decisions
In New York, it is clear that a general partner filing a Chapter 7 case necessitates a dissolution of the partnership. However, it is equally clear that a partnership is not terminated by such a dissolution and may continue until the winding up of its affairs is completed. This anomaly has led to much confused case law that is difficult to reconcile. The most common type of partnership to file bankruptcy is a law firm, which perhaps goes a long way in explaining the confused state of the statutory and case law.
A partnership Chapter 7 filing can have income tax consequences for the individual partners if the Trustee is successful in selling partnership assets. The income generated from such a Trustee sale may be taxable to the partners and not to the bankruptcy estate, since a partnership is a “pass through” tax entity that does not pay income taxes, and the bankruptcy estate generally assumes the taxpayer status of the debtor.
A partnership Chapter 7 bankruptcy filing can have many unintended and unwanted consequences to the individual partners, and should only be undertaken after consultation with competent bankruptcy counsel.