Chapter 7 Bankruptcy for Partnerships

Chapter 7 bankruptcy is rarely a good option for partnerships. Here's why.

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A partnership is allowed to file for Chapter 7 bankruptcy. However, depending on the type of partnership and the value of the partnership assets, filing for Chapter 7 may not be a good solution for the partners. In fact, there are several big reasons why Chapter 7 is often not helpful to partnerships.

Liquidation Under Chapter 7 Bankruptcy

Chapter 7 is called a liquidation bankruptcy. When the partnership files the case, a trustee is appointed to sell or otherwise liquidate the assets of the partnership. The trustee then distributes the cash proceeds to creditors. In most cases, any business activity stops once the Chapter 7 is filed and the trustee’s job is limited to selling off the assets and pursuing recovery of money through lawsuits. An exception is rental property -- in some cases a trustee might continue to collect rents and maintain the property until it is sold.

The Type of Partnership Determines the Partners' Liability

There are different type of partnerships. A partner's personal responsibility for partnership debt depends on the type of partnership it is.

General partnership. This is the simplest form of partnership. In a general partnership, the partners (called “general partners”) are personally responsible for all of the debt of the partnership.

Limited partnership. A limited partnership has both general partners (one or more) and limited partners. Limited partners are not responsible for the debt of the partnership unless they personally guaranteed a specific debt. General partners are responsible for all of the debt.

Limited liability partnerships. Some states have limited liability partnerships which may further limit a partner's responsibility for unpaid partnership debt. State law determines a partner's responsibility in these types of partnerships.

The Effect of Chapter 7 Bankruptcy on Partnerships and Partners

There are several reasons why Chapter 7 bankruptcy is often not beneficial to a partnership.

No discharge. A partnership does not receive a discharge in bankruptcy.

Stop business operations. A partnership will usually not continue to operate after a Chapter 7 bankruptcy.

Partners still liable for debts. Even more importantly, bankruptcy does not change the partners' responsibility for partnership debts. In fact, filing for bankruptcy may make it more likely that general partners will be sued to cover partnership debts. Here's how.

  • Partners that were liable for partnership debts before the bankruptcy (these are usually general partners) remain liable for partnership debts not paid in the bankruptcy.
  • Limited partners lose their investment in the partnership and creditors can sue them outside of bankruptcy on guarantees they signed.
  • There is no co-debtor stay so while the bankruptcy is pending, creditors can sue partners who have guaranteed the partnership debts.
  • If liquidation of the partnership assets does not result in full payment of the partnership debts, the bankruptcy trustee can sue the general partners to recover the funds necessary to pay creditors in full.

The Trustee’s Right to Sue General Partners

Outside of bankruptcy, any given creditor can sue one or all of the general partners to collect the money owed to that particular creditor. However, while some creditors may sue the general partners, it is unlikely that all of them will. So outside of bankruptcy, it is likely that the general partners will have to repay some, but not all, of the partnership debt.

This changes when the partnership files for Chapter 7 bankruptcy. If the money that the trustee gets from selling or liquidating partnership assets does not cover the creditors' claims in full, the Chapter 7 trustee can sue the general partners for the remaining amount due.

The trustee can choose to sue only one or a few partners, rather than all of the partners. For example the trustee can sue the partners that have the most personal assets. This means that one or a few partners may end up paying an amount owed by all of the partners. If a partner ends up paying more than his or her fair share, he or she can sue the other partners outside of bankruptcy for contribution.

Restriction on General Partners' Right to Transfer Personal Assets

The difference between the total dollar amount of creditor claims in the bankruptcy and the amount the trustee recovers from the sale or liquidation of the assets is called a deficiency. This is the amount that the trustee can collect from the general partners.

Since liquidating the partnership assets to determine the deficiency amount can take some time, the bankruptcy court has the power to restrict the general partners' rights to transfer their own assets while the amount of the deficiency is being determined. The court may prohibit the general partners from transferring personal assets or may require them to post a bond or use another means to assure the court that a transfer of assets will not mean that they cannot later pay a deficiency.

Tax Consequences of Liquidating a Partnership in Chapter 7

Generally, partnerships do not pay federal taxes. Gains and losses pass through to the partners. This does not change when the partnership files for Chapter 7 bankruptcy. The Chapter 7 trustee will file the partnership tax return but any gains or losses pass through to the partners.

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