Negotiate the Settlement of Its Debts in the US Without Filing for Bankruptcy
A small business can negotiate the settlement of its debts in the US without filing for bankruptcy. It is a creditor by creditor settlement only, requiring the agreement of each individual creditor, as it is a private contract. One creditor may agree to settle a debt for 40 cents on the dollar while another creditor will not agree to a settlement and continue collecting. A judge can not force a holdout to agree. Further, there is no automatic stay when negotiating a settlement meaning lawsuits and bank levies and routine daily debit transactions from merchant cash advances will continue until each settlement agreement is signed. Settlement is a good choice if the business has only a few unsecured creditors and has cash or assets to offer as a lump sum and has no pending judgments. Bankruptcy is a better option if there are many creditors, if holdout creditors have to be bound, or if money is being collected against the operating bank account.
Personal Exposure
The first thing an owner needs to sort out is personal exposure, because that often decides the whole strategy. Many small business loans, leases and cash advance agreements carry a personal guarantee from the owner. A settlement with the company does not necessarily resolve the guarantee, so the written agreement should expressly release the guarantor. Bankruptcy has a related limit. Under 11 U.S.C. § 727(a)(1), a debtor that is not an individual, such as a corporation or LLC, gets no discharge in Chapter 7. A Chapter 7 case liquidates an entity but does not wipe its debts away. For that reason, guaranteed debt often has to be dealt with through the owner’s own negotiations or the owner’s own case.
Unpaid Payroll Taxes
There is another large set of pitfalls such as unpaid payroll taxes. These are not paid simply because the owner pays other creditors. The IRS can assess a “responsible person” with the Trust Fund Recovery Penalty under Internal Revenue Code 6672. To be assessed the “responsible person” must “willfully” have failed to pay over the income tax and employee Social Security and Medicare tax withheld from wages. The employer’s matching share of the tax is not included in the trust fund recovery penalty. A “responsible person” may be an officer, controlling owner and any one with discretion to decide who gets paid. The IRS generally has 3 years to assess a trust fund recovery penalty. An assessment is proposed through the use of Letter 1153, and the proposed assessment allows the individual to appeal within 60 days. Preferential payments to suppliers over payroll taxes can complicate matters further.
Canceling of Debt Is Usually Considered Taxable Income
When a debt is cancelled, there may be tax implications. Its treatment for tax purposes varies depending upon whether it is forgiven outside or inside the bankruptcy. Canceling of debt is usually considered taxable income. For example, if you have $1,000 in debt and you pay it off for $400, you owe taxes on the remaining $600 according to the IRS. Banks, credit unions, federal agencies and institutions whose business is lending money must send a Form 1099-C if $600 or more is canceled after an event such as a settlement that is less than the total amount due. You must report the income even if you don’t get a form.
Debt cancelled in a bankruptcy is excluded from income only if you are the debtor and the discharge comes from the bankruptcy court, either by granting the discharge or confirming the plan. The greatest tax advantage for a debtor outside of bankruptcy is the insolvency exclusion. The insolvency exclusion may not be the tax windfall that the debtor assumes it to be. It is only to the extent that the liabilities are greater than the fair market value of all of the debtor’s assets just prior to the cancellation. This includes all of the debtor’s retirement accounts and other assets that the creditors cannot touch. The IRS example of an insolvent taxpayer with $3,000 in liabilities greater than the fair market value of his assets, with $5,000 in debt canceled: “The taxpayer must include in gross income $2,000.
The exclusions are on Form 982, but have a cost. The amount excluded under the bankruptcy exclusion or the insolvency exclusion must be applied to reduce tax attributes, starting with the net operating loss and possibly leading to higher taxes in future years.
Recovery by the Trustee of Preferences
The other risk is that the debt restructuring fails and the business ends up filing for bankruptcy. The bankruptcy trustee can “turn back the clock” on any payment of the pre-existing debt in the 90 days prior to the filing (see 11 U.S.C. 547, Recovery by the trustee of preferences) if the payment was made to a “creditor.” If the payment was made to an “insider” (e.g. owner of the business) the clock is extended to one year. The trustee must show that the debtor was insolvent, and that the creditor received more than it would have received in a Chapter 7 liquidation. Under the bankruptcy code the debtor is presumed insolvent during the 90 day period. For business cases, the bankruptcy code also has a “small preference” floor below which the trustee can’t recover transfers.
Present law sets this amount at $8,575. Thus, the payment of the bulk amount by the debtor to a single creditor (which could be the business loan that was personally guaranteed by the business owner) may be “recovered” by the trustee, and distributed among all creditors.
Merchant cash advance debt is particularly useful to look at prior to negotiating, because the terms of the agreement may not be enforceable. The attorney general of New York Letitia James announced a $1.065 billion judgment and settlement with Yellowstone Capital and affiliates in January 2025, alleging that the company’s cash advances were actually loans with interest rates of up to 820% annually. As a result of the settlement, $534,552,724 of balances owed to the company for over 18,000 businesses were waived and a payment of $16.1 million was made. Yellowstone was required to cease collection and abandon enforcement proceedings, vacate unpaid judgments and release certain liens, and businesses were provided 6 months to petition the court to vacate. It depends on the terms of the cash advance and the state law as to whether a particular cash advance can be contested as a disguised loan, and this may impact an owner’s position in negotiations.
Subchapter V of Chapter 11
Another important alternative to a negotiated resolution for an operating company is filing a bankruptcy petition under Subchapter V of Chapter 11. Congress established Subchapter V in the Small Business Reorganization Act of 2019. Under Subchapter V a trustee is appointed to facilitate the debtor’s entry into a consensual plan. The debtor is not required to pay quarterly fees to the U.S. Trustee. The fee to file a Chapter 11 case is $1,738 versus $338 under Chapter 7. Subchapter V requires the debtor to submit a plan of reorganization within 90 days, 11 U.S.C. § 1189, unless an “excusable delay” is allowed. Under § 1191 the court may confirm a plan over the objection of creditors without applying the absolute priority rule. Consequently, the debtors can retain their equity if they devote all of their future disposable income to a plan for a three-to-five year period.
The debt limit for cases filed in late 2026 is $3,424,000. A temporary $7.5 million debt limit expired on June 21, 2024. The House of Representatives passed the Bankruptcy Threshold Adjustment Act (H.R. 7730) on September 16, 2026. The bill was passed in the Senate unchanged on September 28. It is still awaiting the President’s signature as of early October. The Bankruptcy Threshold Adjustment Act would establish a permanent $7.5 million debt limit for Subchapter V cases. It would also make adjustments to the debt limit for inflation every 3 years. It would replace the current $526,700 and $1,580,125 unsecured and secured debt limits for Chapter 13 cases for sole proprietors with a single $2.75 million debt limit. The change in debt limits would only apply to cases filed on or after the law’s enactment. Businesses with debts between $3.4 million and $7.5 million should take into consideration the timing of when to file.
Settlement is usually much cheaper. It is also private. It is the right answer, if there are a few willing unsecured creditors, and if there is sufficient cash flow to make offers. It is not so good, if the secured creditors can take the collateral, if the problem is unpaid payroll taxes, or if there are one or two holdouts to keep suing you. If the business must close, rather than be reorganized, there is another alternative: an assignment for the benefit of creditors under state law. An independent assignee sells the assets of the business and pays creditors outside of bankruptcy. An assignment might be faster and cheaper than a Chapter 7 bankruptcy.
