Chapter 7 Bankruptcy for Corporations and LLCs

Corporations and LLCs rarely file a business bankruptcy using Chapter 7. Why? Chapter 7 won't help keep the company open. Chapter 11 is the bankruptcy type that helps struggling businesses restructure debt payment obligations to benefit the company and its creditors. It's the chapter used most by LLCs and corporations declaring bankruptcy.

Also, closing an LLC or corporation by filing a Chapter 7 business bankruptcy can be risky, so LLCs and corporations usually wind up outside bankruptcy. In most cases, business owners fare better filing their own Chapter 7, 13, or 11 bankruptcy after a company closure.

If you're shutting down a company and considering a Chapter 7 business bankruptcy, or if the business has already closed, you'll want to understand the following:

• how personal and business Chapter 7 bankruptcies differ
• what happens in a Chapter 7 business bankruptcy
• how Chapter 7 could benefit an LLC or corporation, and
• the risks associated with a business Chapter 7 filing.

We also explain why winding down a corporation or LLC is more expensive in Chapter 7 bankruptcy, when you'd want to file your own bankruptcy case, and more. Once you've learned about corporations and LLCs in bankruptcy, check out the resources provided at the end of the article. You'll find links to applicable bankruptcy forms and additional articles we think you'll enjoy.

Is Chapter 7 Bankruptcy a Personal or Business Bankruptcy Chapter?

It can be either. Both businesses and individuals file Chapter 7 when they don't earn enough to pay their debts. Whenever a company files for Chapter 7 bankruptcy, classifying the case is simple—it will be a Chapter 7 business bankruptcy.

However, you can't assume that every bankruptcy filed by an individual is a personal bankruptcy because an individual filer's status doesn't determine whether it's a business or personal bankruptcy. You must look at the type of debt involved.

Here's the rule.

If most of an individual filer's debts are "business-related"—incurred while pursuing a profit-generating business venture—the case is a business Chapter 7 bankruptcy. If most of the individual filer's debts are "consumer" debts related to running a household, the Chapter 7 case is a personal or "consumer" bankruptcy.

Example. Let's suppose that Jen closed down Cool Jump, LLC, an indoor trampoline business after rising electricity costs drove her AC bill to an unsustainable level. In this situation, a Chapter 7 case could be a business or consumer bankruptcy, depending on who files and the debt owed.

• If Jen puts Cool Jump, LLC in Chapter 7, the Chapter 7 case will be a business bankruptcy involving Cool Jump's debt only, all of which is business-related.
• Suppose Jen files for Chapter 7 herself and owes $30,000 in medical debt, a $125,000 personal guarantee for Cool Jump, LLC's lease, and $50,000 of credit card debt (she charged household expenses so she wouldn't need to draw a salary). Because the $125,000 lease debt is business-related and exceeds her $80,000 personal debt, the Chapter 7 matter would be a business bankruptcy.
• Suppose Jen files for Chapter 7 herself. However, before filing, she negotiates Cool Jump, LLC's lease and pays it off with the trampoline sales proceeds. When Jen files for Chapter 7, she has $30,000 in medical debt and $50,000 in personal credit card debt. The Chapter 7 case would be a consumer bankruptcy.

Why does it matter whether a Chapter 7 case is a personal or business bankruptcy? Unlike consumer filers, business filers don't need to qualify for Chapter 7 bankruptcy by passing the means test, which can be a big deal. Here's how it works.

Suppose you take a high-paying job shortly after closing a business, and your wages are so high that you don't pass the means test. You won't have to take the means test if most of your debts are business-related and will still be able to wipe out all qualifying debt in Chapter 7.

However, there's a caveat. Even though you don't have to meet the means test requirements, the bankruptcy court will examine your income and expenses. If the difference shows you can afford to pay a reasonable amount to creditors, you won't qualify for Chapter 7 and will have to file for Chapter 13 or 11.

Check your business bankruptcy status with a bankruptcy lawyer. Courts use different standards when determining whether most of a filer's debts are business-related or consumer . Your local bankruptcy attorney can explain the standard and assist with the appropriate calculations.

What Happens When an LLC or Corporation Files a Chapter 7 Business Bankruptcy?

Not much, other than in most cases, the business closes. When you put an LLC or corporation in Chapter 7, the Chapter 7 trustee appointed by the bankruptcy court will do the following:

• review the bankruptcy paperwork
• sell the business assets
• solicit proof of claim forms from creditors, and
• distribute the funds to creditors according to the bankruptcy payment rules.

It might seem like a good way to go, given that the trustee would do most of the work. But the Chapter 7 process can be expensive and risky for LLCs and corporations. We explain why you'd likely be more satisfied filing for bankruptcy yourself below.

What Won't Happen When an LLC or Corporation Declares Chapter 7 Bankruptcy?

The company won't receive a debt discharge, the order that erases the obligation to repay its debt. This fact surprises most people considering putting a defunct company into Chapter 7. But believing bankruptcy will erase a business's debt and, more importantly, the owner's personal liability to pay the business debt is a common misunderstanding.

Chapter 7 doesn't eliminate the debt liability of an LLC or corporation because a closed company doesn't need a discharge. Creditors can't collect from a company that no longer exists.

This system also allows creditors to collect from people who agreed to be personally liable for the business's debt—a result most business owners aren't happy to learn.

Similarly, a closed business doesn't need property, so the trustee sells all the assets. Unlike in a personal Chapter 7 bankruptcy, LLC members and corporate shareholders can't use bankruptcy exemptions to take business property out of the business's Chapter 7 case and keep it for themselves.

How to Eliminate Personal Liability for Business Debt Using Chapters 7, 13, or 11

Instead of putting the corporation or LLC in Chapter 7—which doesn't erase personal liability and often causes more problems—you can fix your personal liability problem in one of two ways:

• You can erase a personal guarantee or other business debt liability by filing for bankruptcy yourself. Your assets and debts will determine whether Chapter 7, 13, or 11 will be best for you. Learn about the differences between Chapters 13 and 11.
• When bankruptcy isn't feasible—usually because your assets are worth more than the business debt—consider negotiating the amount you owe with the creditor outside of bankruptcy. Any deal you reach would likely be better than the outcome in bankruptcy. You'll understand why after reading about the costs of closing a business using Chapter 7 below.

A business bankruptcy lawyer can assess your situation, develop a strategy, and assist you with whatever level of implementation you need.

Why Would an LLC or Corporation File for Chapter 7 Bankruptcy?

Filing for Chapter 7 bankruptcy unwinds LLCs and corporations publicly and transparently, which can be a good approach when creditors are concerned they won't receive their fair share of the company assets.

Allowing the Chapter 7 trustee to inventory and sell the assets and distribute the sales proceeds according to bankruptcy's priority payment rules can help alleviate problems by reducing the chances of asset-related lawsuits.

What Risks Come With Closing an LLC or Corporation Using a Chapter 7 Business Bankruptcy?

The biggest downside? A bankruptcy case provides an easy way for creditors who would otherwise get little to nothing to seek payment from stakeholders personally in "pierce the corporate veil" actions.

A creditor who initially wrote off a debt will start thinking about getting paid again after receiving notice of a bankruptcy filing, and many will call a bankruptcy attorney to find out what to do next. Because the case is already in bankruptcy court, filing a bankruptcy lawsuit or "adversary proceeding" would be relatively simple.

Because all lawsuits are costly to defend, even those based on tenuous grounds, most officers avoid the risk by unwinding companies outside of bankruptcy.

How Much Does It Cost to Close an LLC or Corporation Using Chapter 7?

Using Chapter 7 to close a company is often more expensive than it would seem. You must hire an attorney to represent the company, so the most apparent expense involves legal fees. The less obvious cost? You'll pay more if you're obligated to pay its business debt.

The trustee will likely sell the company's property for less than the actual value because people buying bankruptcy assets want a deal. But that's not all. Not only will the trustee get less, but you'll also pay the trustee a hefty percentage of the sales proceeds. Here's where you can find out how much you'll pay the trustee in Chapter 7 bankruptcy.

The decreased amount paid toward the business debt will leave you with more to pay toward your business debt liability.

Why Chapter 7 Works Well for Service-Oriented Sole Proprietors Only

Most business bankruptcy lawyers agree that overall, Chapter 7 bankruptcy isn't optimal for almost all business types and is a poor choice for partnerships and sole proprietors whose companies rely on expensive tools, products, or real estate.

Why Chapter 7 Doesn't Don't Work for Partnerships

Partnerships rarely file for Chapter 7 business bankruptcy because, like LLCs and corporations, partnerships aren't entitled to a debt discharge. Also, a Chapter 7 filing can put partners' personal assets at risk.

Because partners are personally liable for partnership debt, the trustee in a Chapter 7 bankruptcy case can sue the partners personally to recover cash to pay the partnership's debts. Learn more about partnerships in Chapter 7 bankruptcy.

Chapter 7 Bankruptcy and Sole Proprietors

When a sole proprietor files for Chapter 7, all debts and assets—business and consumer alike—are included in the bankruptcy because the company and individual are essentially the same. Sole proprietors sometimes benefit from Chapter 7 because they can erase personal and business debt in the same case. They're also the only business entities that can, in some instances, file Chapter 7 and keep a business open.

If you're a sole proprietor wondering whether Chapter 7 would be a good idea, consider two things:

• Do you want to keep the business open?
• Can you protect needed business assets with bankruptcy exemptions?

Here's how these factors will affect a sole proprietor in a Chapter 7 analysis:

• Chapter 7 works well when closing the business. If keeping the company open isn't an issue, a sole proprietor can easily use Chapter 7 to erase business and personal debt and move on after a business closure.
• Chapter 7 works well to keep open a service-oriented business. Service-oriented businesses, like bookkeeping or accounting services, don't rely heavily on real estate, products, or equipment. The trustee can't sell the filer's labor, and bankruptcy exemptions often cover the filer's property needs. The filer could wipe out business and personal debt and continue providing the service after the case ends—possibly even during bankruptcy with liability insurance in place.
• Chapter 7 will close a business with substantial property needs. Chapter 7 won't help a sole proprietor keep open an asset-dependent business. The trustee would sell assets not covered by bankruptcy exemptions and, in most cases, effectively close the business.

A business bankruptcy lawyer can explain your options and, if Chapter 7 won't be beneficial, help you determine whether Chapter 13 or 11 would be a good option.

Navigating Your Bankruptcy Case

Bankruptcy is essentially a qualification process. The laws provide instructions for completing a 50- to 60-page bankruptcy petition, and because the rules apply to every case, you can't skip a step. We want to help.

Below you'll find resources we think you'll enjoy or go to TheBankruptcySite for more easy-to-understand articles.

We wholeheartedly encourage research and learning, but online articles can't address all bankruptcy issues or the facts of your case. The best way to protect your assets in bankruptcy is by hiring a local bankruptcy lawyer.