When the payments stack up faster than the revenue comes in, Chapter 7 can look like a clean slate. At Delancey Street we negotiate with merchant cash advance funders, lenders and other creditors on behalf of business owners, and the owners we talk to often ask what bankruptcy would actually erase. The honest answer depends on if your company is a corporation, a partnership, or a sole proprietorship. And it also depends on whether or not you signed a personal guarantee. Below are eight kinds of debt Chapter 7 can wipe out, and four it can’t.
It helps to know what filing involves. First, you fill out a petition, along with several other forms that ask about your home, how much you spend and make every month, what bills you owe, what property you own, what financial transactions you have and property you sold or disposed of in the last two years. The filing freezes all collection activity. A bankruptcy trustee gets appointed to liquidate your company’s assets to pay your debts. The bankruptcy law lets you keep “exempt property”. Most states allow you to keep some amount of your home’s equity, clothing, furnishings, unused Social Security benefits, a car, tools of your trade.
Discharge Their Personal and Business Debts
The first two debts belong together. When you’re a sole proprietor there’s no legal distinction between you and the business, so the business’s debts are also your debts. Thus when you file Chapter 7 you discharge those debts, along with the debts you’ve personally incurred. So your eligible business debt and your eligible personal debt can go in one case filed in your own name. If the amount of business debt you have is greater than the amount of personal debt you have, most likely you won’t have to pass the means test. The bankruptcy exemptions can protect personal and business assets so you may be able to continue the business. This works best for service-type businesses (personal trainer, accountant, etc.), because very few states allow you to keep much property. If you have a business like a restaurant or clothing store, the trustee will probably sell the nonexempt property and you may not be able to operate the business anymore. Maybe the trustee will try to sell the company.
Debts three and four matter most to owners of LLCs and corporations. The personal guarantee is where your business can become personal. A personal guarantee is basically a promise to pay if the business cannot. Signing a personal guarantee means that you are responsible for the debt no matter how the business is structured. Generally, a shareholder who signed a personal guarantee or cosigned a loan won’t be relieved of liability when the company enters bankruptcy, unless that shareholder also enters a Ch. 7 case in their own name. Filed that way, both the guaranteed debt and the cosigned debt can be discharged.
Number five is your share of a general partnership’s debt. For a general partnership, each partner is personally responsible for the partnership debt, so if the partnership assets do not cover the partnership’s debts, the trustee or creditors may try to collect the remaining debt from each partner’s personal assets. It’s usually better for a general partnership to close its doors and then each partner file a personal Ch. 7 to discharge their personal and business debts. Most partnership agreements terminate the partnership if any partner files for bankruptcy.
Six and seven are the personal obligations owners carry on company debt. The bankruptcy law can also cut off your personal obligations on the corporate debts. For LLC owners, personal bankruptcy will allow them to discharge their responsibility for commercial debts. And number eight is everything else that qualifies. Chapter 7 is built for it: It allows you to wipe out most of your obligations and start over fresh.
Can’t Be Discharged
Now the four that survive. The first is the company’s own debt. A partnership is also a separate legal entity, so it can file Ch. 7 on its own, but its debts are not discharged. The partners cannot use exemptions, and the trustee liquidates the business and sells its assets. A corporation can file as well, and just like a partnership, the corporation’s debts are not discharged. It benefits in that assets are liquidated in an orderly fashion and paid out to creditors by the trustee rather than the owners. Rarely worth the trouble. In fact, filing Chapter 7 gives creditors a perfect occasion to argue the corporation’s owners failed to observe corporate formalities (”piercing the corporate veil”) and should be held personally liable. And if they win? The corporation’s debts become your debts. An LLC is treated almost exactly like a corporation and has the same pitfalls.
The other three are personal. Student loans can’t be discharged unless your case can fit an exception to the law. Alimony and child support are left standing, and those are two separate debts on this list, not one.
Even when the discharge goes your way, the price is real. You lose a lot of possessions you’ve worked hard to accumulate. Your credit record and rating are damaged for a long time. For at least seven years you can’t get on another debt reduction program. The process is relatively short. The damage it leaves behind is not.
Before you weigh any of it, answer two questions. What type of business are you? Do you have any personal guarantees? Those answers decide which of the eight apply to you, and how many of the four you would still be carrying afterward. Ch. 7 is not magic.
Besides Ch. 7, the business could reduce its debt by negotiation with creditors. The business might be able to sell its property at higher prices than fire-sale prices after bankruptcy. All this can reduce pressure on the people responsible for the debt. That’s the work we do at Delancey Street: our senior advisors negotiate with funders and lenders for less than the full balance owed. We are not a law firm, though, and when bankruptcy is the better path, we refer owners to bankruptcy counsel. Either way, Talk it through.
