If you own a limited liability company (LLC) and you personally declare bankruptcy, what happens next tends to depend on whether you are the company’s sole owner or you share ownership with other members.
What is Bankruptcy?
In the United States, bankruptcy is a legal process in which you petition the U.S. Bankruptcy Court to discharge or reorganize your debts so that you can start over with your debt load eliminated or significantly reduced. Individuals can file for bankruptcy under Chapter 7 or Chapter 13 of the U.S. Bankruptcy Code.
What is Chapter 7?
Note that the Chapter 7 is the most common bankruptcy procedure for individuals. The court appoints a trustee to liquidate your assets and distribute the proceeds among your creditors. However, the Bankruptcy law permits you to designate certain assets as exempt from liquidation.
Note that the property you can claim as exempt depends on your state. Business assets are usually not exempt, unless they are tools of the trade that you need to work. For instance, if you are a contractor, your tools, which are literally the tools of your trade, may be exempt. But every other non – exempt asset becomes part of the bankruptcy estate used to pay off your debts.
What is Chapter 13?
The Chapter 13, also known as reorganization, is always for debtors who do not qualify for Chapter 7. Note that you may be able to file for Chapter 13 bankruptcy if you have continuing income that will allow you to pay back at least some of your debts. Instead of liquidating your assets, you keep them and propose a repayment plan for the court’s approval.
Nonetheless, when you declare Chapter 7 bankruptcy, your ownership interest in your LLC is an asset that becomes part of your bankruptcy estate subject to liquidation for paying your creditors. As your LLC’s sole owner, the bankruptcy trustee may mandate you to shut your business down, at least temporarily, to assess the value of the company and its assets and to prevent you from incurring further debt.
Note that the trustee may also choose to collect any accounts receivable or sell the business entirely and use the proceeds to compensate your creditors. If, however, the trustee determines that selling the business would not generate enough income to be worthwhile, they may leave it for you to continue running instead of liquidating it.
But if you are one of multiple LLC members, have it in mind that the share of the company becomes part of your bankruptcy estate, but the trustee likely will not interfere with the business unless you are the majority owner.
Even though you have both an economic and a management interest in the LLC, only the economic interest becomes part of the estate. If the trustee chooses to sell your interest, the purchaser cannot participate in company management. The trustee may also request the court to issue a charging order against the LLC, which entitles them to collect your share of distributions to pay down your debts.
It is always advisable to consult the LLC’s operating agreement before you file for bankruptcy. This document may contain provisions addressing this situation. For instance, you may be mandated you to sell your interest back to the company or the other members beforehand or to grant the company a right of first refusal before selling your interest.
3 Consequences of Personally Filing for Bankruptcy
Indeed there are so many things to think about before you decide whether filing personal bankruptcy is in your best interest. Coupled with the possibility of losing property, below are a couple of other consequences that may be important to you.
1. Payments made to family or friends may be reversed
Note that the bankruptcy trustee will have to look at all payments and asset transfers you made during the year or two before the bankruptcy filing to make sure that you didn’t make “preference” payments to certain creditors.
However, if you made payments on a business loan to relatives or close business associates in the year before filing, or transferred business or personal property to them for little or no payment in the two years before filing, a bankruptcy court can reverse the payment or transfer.
Also have it in mind that the trustee can and will “recapture” (take back) payments you made to family or friends to divide them equally between all creditors. If the money you paid to family or friends has been spent, the trustee can choose to sue the recipient of the payment to get it back. Also have it in mind that if the bankruptcy judge decides you made the payment or transfer for fraudulent purposes, your bankruptcy case could be dismissed.
2. Damaged credit rating
If you personally file for bankruptcy, it will go on your credit report and stay there for ten years. In theory, this information can hurt your chance of acquiring a subsequent mortgage, car loan, other credit, or possibly even a job. But in practice, if you are far over your head in debt, it is a good thing that you won’t be able to immediately run up more debt (after all, you can file Chapter 7 bankruptcy only every eight years).
In addition, if you take sensible steps to rebuild your credit and can show you have a job; many lenders might decide to extend at least some new credit within a year or two. Do not forget though, that no one knows yet what upcoming credit markets will look like.
3. You may need to get out of an LLC before filing for bankruptcy
If you are a partner in a partnership or a member of a multi – member LLC, you may have signed a buy – sell agreement that mandates you to terminate your ownership interest before filing for bankruptcy. If you don’t, you open yourself up to a lawsuit from your co – owners. A local small business attorney can help you assess your obligations and options here.
If your business was set up as an LLC and is still operating when you file a personal bankruptcy, that filing does not “stay” any litigation against the corporation because it is a separate legal entity, a separate “person.” To the extent the dispute and/or lawsuit is against you personally, that portion would be stayed.
However, it can be challenging to know whether bankruptcy is the right move for you. Before you make the decision, consider consulting an attorney that can help you determine the best course of action and guide you through the process.