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When is Declaring Business Bankruptcy an Option?


Even in a non-pandemic year, some of your business-owning clients may find themselves in the difficult position of having to decide whether or not they should declare bankruptcy. Financial planning expert Bryce Sanders discusses some signs this is the right option, as well as which type of bankruptcy clients should consider.

Dec 14th 2020
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It’s not supposed to happen. Businesses are established with the goal of operating indefinitely.

King Arthur Flower (an America’s Test Kitchen sponsor) started business in 1790. Cigna followed in 1792, and 1795 gave us Jim Beam bourbon. But many businesses declare bankruptcy.  We may see more post-pandemic in 2021. When should a business-owning client consider bankruptcy for their business?

The simple answer is bankruptcy should be considered only as a last resort. Your client may come to you and float the idea, especially if things aren’t going well. It’s often an expensive option. If your client wants to walk away, there are easier choices to consider.

  1. Selling the Business: It’s a logical option if your client is getting tired of running the business and the next generation doesn’t want to follow in their footsteps. This assumes the business has a value after liabilities are matched against assets. As their accountant, you would be involved in helping them prepare the business for sale.
  2. Closing the Business: It’s the option that’s preferable to bankruptcy. The client winds it down. Assuming it’s organized as an entity with limited liability protection (corporation or LLC), there may be creditors who don’t get paid. That’s a business risk they took. They were able to check credit reports before extending credit. If it’s a newer business, the bank may have required the owner to assume personal liability for loans they extended. Those debts follow you. There are also debts, like tax bills and Social Security payments, that take priority.
  3. Declaring Bankruptcy: Most accountants use a simple, logical calculation. If the liabilities of the company far exceed the fair value of the assets and there is no reasonable hope the business could get out from under its debts, then declaring bankruptcy is an option. This requires the expertise of a bankruptcy attorney.

Scenarios When Bankruptcy is an Option to Consider

Your client owns a local business. They have problems.

  1. The Debts are Overwhelming: There is no way they could realistically renegotiate with creditors to keep the wolf from the door. The penalty interest rate they are paying is at the upper legal limit.
  2. Mismanagement: Employees have been stealing from the company. High-value inventory has disappeared, and money is missing. There is no realistic path to getting it back.
  3. The Business Model Has Dramatically Changed: Your client had one major client. This often happens when you sell to government entities. The client changed their buying criteria. Perhaps they are only buying from large vendors. There’s no way this is going to change. The source of revenue has disappeared.
  4. The Tax Man Wants His Money Now: The business is seriously behind in paying taxes. Penalties have driven the amount owed up. The customers of the business are told to pay the government directly, similar to a tax lien on a person’s paycheck at work. 
  5. No One Will Lend to the Business Anymore: There always seem to be sources of distress financing, but those loans need to be secured by assets far in excess of the amount borrowed. The business can no longer get credit.
  6. Major Liability Lawsuits are Pending: The company produced a product that unintentionally harmed people. There is either no insurance coverage, or the insurance company sees it as a risk they aren’t obligated to cover. The company is an ongoing concern, yet the value of the business and its assets are far below the ultimate liabilities.

What Can Your Client Do?

Your client has considered all the options. Bankruptcy is the only logical answer.

The next question is, what courses of action are available? If the client wants to cut their losses and walk away, Chapter 7 bankruptcy is probably the logical choice. If the client feels the situation can be turned around but they need some debt relief, Chapter 11 bankruptcy is logical to explore.

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