Bankruptcy refers to a situation where an individual or a business has liabilities that exceed assets, or where the person or business is insolvent by reason of not being able to meet financial obligations as they become due. Virtually anyone or any type of business entity can start a bankruptcy proceeding by filing a petition in federal bankruptcy court. The filing of a bankruptcy petition affects all creditors of the debtor. There are many different categories of creditors, including: secured creditors, priority creditors, and unsecured creditors. Inevitably, every business is going to run into situations where customers file bankruptcy. Businesses will end up filing bankruptcy as well.

What is the effect of filing a bankruptcy petition?

The filing of a bankruptcy petition is a lot like filing a lawsuit in the sense that the act of filing simply starts a legal proceeding without any guarantees of the outcome. The debtor will make allegations, but there is no guarantee that the court will declare the debtor bankrupt or grant any other requests. A business bankruptcy is a statutory process with creditors and other third parties given the opportunity to challenge and object to the relief being sought by the debtor.

Upon the filing of a bankruptcy, an “automatic stay” stay goes into effect that stops creditors from taking any further action to try to collect their debts unless or until the bankruptcy court decides to the contrary. The automatic stay grants debtors temporary relief from their financial problems, which gives them the opportunity to develop a plan to resolve their problems.

The automatic stay is only temporary, and there are any number of ways that a creditor can get relief from the bankruptcy court to proceed with trying to collect its debt. One common way is to file a petition or motion with the court that asks for relief from the automatic stay. In the case of a secured creditor, a court will look to see if the creditor is adequately protected. For example, a creditor with a lien on real property may still be adequately protected if there is enough equity and/or the debtor starts making “post-petition” payments again after the filing of the bankruptcy. If there isn’t adequate protection, a creditor may be given permission to proceed with foreclosure or other remedies.

What kinds of bankruptcies are there?

The Bankruptcy Reform Act provides a number of different options. Generally speaking, though, there are four kinds of bankruptcy proceedings that are commonly referenced by the different chapters of the federal bankruptcy code that covers them:

Chapter 7 is the most common type of bankruptcy proceeding. Chapter 7 is available to individuals, married couples, corporations, and partnerships. In this proceeding, individual debtors may seek a discharge of their unsecured debts, meaning that those debts are extinguished by order of the bankruptcy court at the end of the proceeding. Unless there are problems in the case, an individual debtor is usually able to get a discharge within four to six months of filing the case.

As in all bankruptcy filings, the filing of a Chapter 7 proceeding imposes an automatic stay on all creditors, which prevents them from trying to collect their debts without first getting approval of the bankruptcy court. A bankruptcy trustee is appointed to the debtor’s case, who controls all of the debtor’s assets. All creditors must be given notice of the proceeding. The trustee then identifies which assets of the debtor are exempt from the bankruptcy proceeding (such as personal effects, household goods, qualified retirement funds), and those that will be sold to pay off creditor claims.

A Chapter 7 is a liquidation proceeding, which means that the debtor’s non-exempt assets, if any, are sold or otherwise liquidated by the trustee. The proceeds are distributed to creditors according to the priorities rules established by the federal bankruptcy code. Any wages the debtor earns after the case is begun are the debtor’s and beyond the reach of any creditor that had claims on the date of filing.

A Chapter 11 is a reorganization proceeding, typically for corporations or partnerships. However, a Chapter 11 proceeding may still be an option for some  individuals, especially those whose debts exceed the limits allowed by a Chapter 13 proceeding.

A business in financial trouble may elect to file a Chapter 11 petition to try to reorganize outstanding debts and continue to operate the business. There’s an automatic stay, just like any other bankruptcy proceeding. Unlike a Chapter 7 proceeding, though, a business that files a Chapter 11 proceeding will become a debtor-in-possession, and there will initially be no bankruptcy trustee appointed. The debtor-in-possession is given an opportunity to prepare a plan of reorganization that must be approved by a majority of the creditors. If a plan is approved by the creditors and is confirmed by the court, it binds both the debtor and the creditors to its terms of repayment. Plans can call for repayment out of future profits, sales of some or all of the assets, or a merger or recapitalization. Generally, the plan of reorganization must provide for paying creditors at least as much as they would have been entitled to be paid in a Chapter 7 liquidation proceeding.

It isn’t easy to salvage a business in a Chapter 11 proceeding, and many of them end up converting to a Chapter 7.

Chapter 12 is a simplified reorganization for family farmers, modeled after Chapter 13. The debtor retains his property and pays creditors out of future income.

Chapter 13 can be used as a simplified reorganization for individuals who operate their business as a sole proprietorship.

When should a business file for bankruptcy?

This is not an easy decision and a business owner should first exhaust all other options. There are also different types of bankruptcy proceedings, so the decision may not be as simple as you think. It’s a good idea to seek legal advice before your company problems become overwhelming. Filing bankruptcy and giving your business a chance to reorganize may outweigh the inevitable drawbacks of filing bankruptcy (loss of the business, hurting credit history, embarrassment). In a business setting, though, there may not be quite the stigma to filing bankruptcy, and it can actually be an effective tool to save a business enterprise.

Isn’t it true that someone can only file for bankruptcy once every eight years?

A: No. This is a common misinterpretation of the rule that a debtor can file more often but can only obtain a discharge once every eight years. While you can only file Chapter 7 and obtain a discharge once every eight years, you can file a Chapter 13 bankruptcy, even if you got a Chapter 7 discharge at least four years ago. There are other strategies that debtors can utilize, as well. For example, you can file a Chapter 7 to discharge those debts that are dischargeable and, then, file a subsequent Chapter 13 to repay those debts that were not discharged in Chapter 7.

Can a business get a discharge?

If you are operating your business as a sole proprietor, you may still be entitled to a discharge. But corporations and other business entities are not entitled to a discharge. A sole proprietor should keep in mind, though, that a bankruptcy filing must include all of the debtor entity’s debts, regardless of how or why they were incurred. This includes both personal and business debts. Thus, it would be difficult for a sole proprietor to treat business debts separately from his or her personal finances. The assets of a sole proprietorship, like business equipment or receivables, are property of the bankruptcy estate unless they are claimed exempt or abandoned by the trustee in a Chapter 7. It may be possible to classify business debts separately and pay them in full in a Chapter 13, if necessary to continue to use vendors. An individual debtor can also reaffirm debts.

What happens to my corporation if I file personal bankruptcy?

Since the corporation is a legal entity different and distinct from its shareholders, the bankruptcy of a stockholder does not affect the corporation. The bankrupt shareholder’s shares in the corporation are an asset of his or her bankruptcy estate. The value of the shares in the hands of the bankruptcy estate is a function of: the value of the corporation. If the value of the corporation is small or negative (if the liabilities are greater than the value of the assets), the trustee in most instances will abandon the corporation.

A corporate bankruptcy shouldn’t directly affect the shareholders. If the officers or shareholders are personally liable for the debts of the business, the automatic stay in the corporation’s case doesn’t prevent creditors from trying to collect from others who may be liable.

It makes no difference if you have made an “S” election for your corporation. Such an election is a matter of tax law. For purposes of the bankruptcy laws, an “S” corporation is treated no differently than a “C” corporation. But any taxable income generated by an “S” corporation after bankruptcy may still be taxable to the shareholders, as the corporation isn’t a taxpaying entity.

What happens if a debtor or a creditor doesn’t follow the bankruptcy rules?

The bankruptcy rules are very complicated. If a debtor fails to comply with the rules or makes misrepresentations to the bankruptcy court, the court may deny a discharge. Debtors have to be very careful to account for everything and to follow the bankruptcy rules. Creditors are not immune, either. They may be subject to similar sanctions if, for example, they collude with the debtor to hide assets. A creditor can also get in big trouble with the bankruptcy court for violating the automatic stay.

Can a debtor give special treatment to certain creditors?

Although the rules can get quite complicated, a debtor cannot give preference to one creditor over another. The preference period for general creditors is three months. It can be as long as a year for family members and other insiders. If a debtor makes a payment in preference to some creditors over other creditors, the bankruptcy court can order the creditors who received the money to pay it back into your bankruptcy estate.

Can a business be forced into bankruptcy?

Yes. If enough is at stake, creditors can start an involuntary bankruptcy proceeding against a business. This doesn’t happen too often, but it does happen when creditors are concerned that a debtor is squandering or misappropriating assets that should otherwise go to pay debts that are owed to them.

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