The Role of Bankruptcy in Business Debt

When a business finds itself in a legal dispute and faces a substantial debt, one question often arises: can the business simply declare bankruptcy and walk away from the responsibilities? It is a common misconception that a company can easily resolve such issues through bankruptcy. However, the answer is more nuanced, and certain debts—such as those from personal injury cases—cannot be discharged.

Can a Business Declare Bankruptcy and Avoid Payment?

For the most part, yes, a company can declare bankruptcy if it owes a significant amount to the person who sued it. This process can significantly reduce or even eliminate the debt if certain conditions are met. However, there are important exceptions. If the debt is due to personal injury caused by the company, then this type of debt cannot be discharged in bankruptcy.

Other debts that cannot be discharged include taxes, personal injury liability, alimony, child support, and student loans. These situations leave the possibility of bankruptcy less advantageous. To really protect your business and personal assets, it is crucial to have proper incorporation and adequate insurance coverage.

Protecting Your Business with Incorporation and Insurance

If you run a business, especially as a self-employed professional such as a bookkeeper or accountant, it is essential to make sure your business is properly incorporated and adequately insured. By setting up your business as a single-member LLC (Limited Liability Company), you can gain significant asset protection. This is particularly important if your business is conducted in a typical home office space.

In my situation, as a self-employed bookkeeper and accountant (not a CPA), I run my business out of a spare room in my house. I am safeguarded by carrying a $1 million professional liability and business owners policy that costs around $1,000 annually. This policy, along with my LLC status, provides me with the best asset protection in my state. As a sole member of the LLC, my personal assets are fully protected, a level of protection I would not have if I were running the business as a sole proprietorship. Additionally, as a single-member LLC, I am taxed similarly to a sole proprietorship, but with the added benefits of asset protection.

The Challenges of Bankruptcy for Businesses

However, declaring bankruptcy is not always the easy solution it may seem. For one, if the company owns any assets after paying all senior debts, these will be available to the person who sued them. Additionally, the company would lose all its intangible assets, such as brand recognition and goodwill. For larger corporations like Apple or Pepsi, losing these intangible assets would be catastrophic.

Furthermore, the entity conducting the business (a corporation or a limited liability company) can only act through its individual members. Therefore, any attempt to intentionally or abusively avoid debt responsibility would be difficult without the individuals involved doing something unlawful.

Bankruptcy Options for Business Debtors

When dealing with business debts, there are typically two bankruptcy options: Chapter 7 and Chapter 11. Chapter 7 bankruptcy offers a fresh start by liquidating the business’s non-exempt assets to pay off debts, but a business debtor is not entitled to a discharge of debt in this case. Chapter 11 bankruptcy, on the other hand, allows the business to reorganize and potentially eliminate certain debts, but it is more likely that a substantial part of the non-judgment debt would also be eliminated and the interests of equity security holders would be affected.

In mass tort cases, more often than not, the business debtor will establish a trust that transfers profits and possibly other properties to pay off the claims of judgment creditors and future claimants who have sustained injuries due to the company's tortious conduct.

Conclusion

While bankruptcy may seem like a straightforward solution to a business’s debt problems, it is fraught with challenges. Proper incorporation and adequate insurance coverage are critical steps to protecting both your business and personal assets from the liabilities of a lawsuit. Understanding the complexities of bankruptcy and its limitations is essential for any entrepreneur or business owner to maintain financial stability and legal protection.