Many of the calls I receive are from individuals who own small or mid-size businesses that are experiencing financial difficulties and need to shut down.  They often assume that they should file a bankruptcy petition on behalf of the business if it is a corporation, partnership or limited liability company.

Often, filing the petition for the business does no good, and potentially could lead to negative consequences.

Let’s look at a common scenario.  Richard owns a small residential construction company, set up as a limited liability company (LLC), that he runs from his house.  Due to the downturn in the real estate market, the business is going under.  It cannot sell its two houses under construction or the two other lots it owns.  The secured lenders have sent notices of default and are starting the foreclosure process.   Richard also cannot pay the company’s sub-contractors or the SBA loan the company took out three years ago, for which he is personally liable.  There is no equity in the houses or lots, so even if he did sell them at market value, the company would not receive an excess above the construction loans.  Although Richard believes the market would get better if he could hang on for a few months, he has few personal assets and cannot keep the company afloat.  Like most small business owners, he has personally guaranteed

Is this company a viable candidate for Chapter 7?  There is a good chance it is not.

If, after getting to the end of his rope, Richard simply “walks away” and lets the banks foreclose on the only assets (the land), and the company essentially has no assets, creditors are left with filing lawsuits against the dead company or against Richard for debt for which he is personally liable.  Richard must then decide (if he has not done so already) whether or not to file a personal Bankruptcy petition.

If, instead, Richard files a Chapter 7 for the company, a trustee is appointed. The trustee inevitably allows the secured lenders to foreclose on the real property, and creditors file claims in the case.  However, the creditors that have personal guarantees then file lawsuits against Richard individually, and he faces personal bankruptcy.  Did he get a real benefit from the business Bankruptcy?  Probably not.

The Chapter 7 trustee for the company takes a look at the books and records of the debtor company and sees that during better days a couple years ago, Richard caused the company to write a check for the down payment on Richard’s house.  Almost a year ago, when the company got its SBA loan, Richard also paid himself and his wife  “bonuses.”   The Trustee for the business then files lawsuits against Richard and his wife for preferential transfers and fraudulent conveyances.  By filing the Chapter 7 for the company, Richard simply invited someone to come in and review everything he had done for the last several years and he bought himself and his wife lawsuits.  Arguably, the fraudulent conveyance claim may not even be dischargeable if Richard files his own Chapter 7 case.  Basically, the business Chapter 7 was something he should have never filed.

However, under some circumstances, a business Chapter 7 may be a good idea.

Circumstances that may warrant a filing for the small business include –

• The business has significant assets that need to be liquidated, and owners would rather move on to other opportunities rather then spend several weeks or months dealing with the liquidation process.  Retail businesses, or businesses with inventory, office furniture equipment, or other unsecured assets may fall into this category.
• I recently filed a business Chapter 7 in which creditors had obtained judgments and were being very aggressive with post-judgment discovery.  Even if the owners filed personal bankruptcy, they still would have a duty to respond to discovery for the business.  Again, the hassle factor may lead to a filing.

There is one other reason for seeing a lawyer early on, and before any foreclosures.  If your business debt is more than your personal debt, you generally qualify for a personal Chapter 7 regardless of household income (though this is not a firm rule in all districts).  In the above example, Richard guaranteed the secured real estate loans of his company and that counts as business debt.  If the property is foreclosed, much of that debt may satisfied at auction and he may end up with more personal debt, since his home loan is considered personal debt.  If Richard’s household income is higher than the median, filing after foreclosure instead of before may mean he has to file Chapter 13 rather than a 7.  By seeing a lawyer early, he would have more choices.