Under the Bankruptcy Code, Title 11 of the United States Code (11 U.S.C. §§ 101), the relief available to business entities under bankruptcy law involves either liquidating corporate assets or restructuring debt through reorganization. While individual business owners or sole proprietors can receive a formal debt discharge, corporations and partnerships do not receive a traditional discharge under Chapter 7 (11 U.S.C. § 727(a)(1)). Rather, the corporate entity winds down and ceases to exist. Business bankruptcy is administered in all jurisdictions under federal bankruptcy law.
The debt relief available depends on your entity type, whether a sole proprietorship, a partnership, a corporation, or an LLC. Several general commercial liabilities are not dischargeable, like payroll taxes and certain civil judgments. Moreover, personal guarantees result in separate personal exposure under federal bankruptcy and California rules. Knowing these limits helps business owners explore restructuring options and map a clear path to financial recovery.
Below are the business debts you can discharge through bankruptcy proceedings.
General Unsecured Commercial Debt and Trade Creditor Invoices
Unsecured commercial debts are those owed to suppliers and vendors for nonpayment of bills. If you have made a series of transactions with certain preferred suppliers just before filing for bankruptcy, the bankruptcy court trustee will scrutinize these transactions.
Under Section 547 of the Bankruptcy Code (11 U.S.C. § 547), payments made to ordinary trade creditors within the ninety days before your filing can sometimes be called back into the bankruptcy estate as preferential transfers. Section 547 requires creditors to give back pre-bankruptcy payments if those payments gave them more than they would get in a Chapter 7 liquidation. However, it protects routine, everyday business transactions under a safe harbor. The aim is to ensure that all unsecured creditors are paid fairly, rather than one supplier being paid in full and the others paid nothing.
Your legal advisor can assist you in reviewing these payments and defending common business transactions with judicious legal strategies. In practical terms, keeping clean accounting ledgers before filing will make trustees less aggressive towards ordinary trade partners.
When a business closes, unpaid vendor bills make up most of the general unsecured debt. If your company is liquidated, these trade debts are included in the bankruptcy estate under 11 U.S.C. § 726. Trade creditors rarely get full payment because they stand behind taxes and secured lenders.
Federal law extinguishes the company's legal debt obligations upon liquidation, but the underlying debt remains until the state dissolution is complete. Once corporate liquidation is complete, your business ceases to exist, and trade debts disappear, protecting you from corporate collection calls. If you opt for Chapter 11 or Subchapter V (11 U.S.C. §§ 1181-1195), you can work out a manageable arrangement to pay off some of your vendor bills over time while preserving your business. Strategically, the decision between Chapter 7 and Subchapter V will depend on whether your business has continuing going-concern value.
Commercial Lease Liabilities and Broken Equipment Contracts
One of the biggest fixed expenses your company is likely to have is rent and equipment leases. As your income decreases and you are unable to pay for your storefront, warehouse, or machinery, you are in control of getting rid of those oppressive contracts thanks to federal bankruptcy law, 11 U.S.C. § 365.
Walking away from an expensive commercial lease through bankruptcy lets you escape the remainder of a long-term rental contract without owing years of future rent. A debtor has the right to assume or reject any unexpired lease, and rejection of the lease is deemed a breach of the contract on the day of bankruptcy filing.
While landlords can still claim unpaid rent, there is a strict federal law governing how much they can recover under 11 U.S.C. § 502(b)(6). Under the law, a landlord can recover damages from a tenant for the termination of a real estate lease only for the amount of rent reserved for the lease's remaining term, whichever is longer, or for 15 percent of the lease's remaining term (a maximum of 3 years). This cap will prevent your business from incurring a significant penalty for breaking a lease.
When you evaluate your physical location and equipment contracts during financial distress, here are some things to keep in mind:
- Examine outstanding commercial real estate leases for performance and discuss with the tenant whether to continue or terminate the lease under 11 U.S.C. § 365(d)(3)
- Evaluate equipment lease and business vehicle financing deals to cut down on unneeded monthly costs
- Figure out your landlord's rejection damage fee limits, versus just typical unsecured debt
- Assess how business relocation affects daily operations and customer access
When a business files for bankruptcy, the rules differ for real estate and movable assets, including machinery and office technology. Equipment leases must be performed or surrendered in accordance with the statutory time limits after an order for relief, in accordance with 11 U.S.C. § 365(d)(10). If you rent the necessary equipment, you can either pay the arrears to keep it or cancel the agreement, return the equipment, and convert any remaining balance into an unsecured debt. Landlords and equipment lessors often retain security deposits.
However, bankruptcy courts enforce strict turnover rules under 11 U.S.C. § 542 to recover estate property that is wrongfully withheld. Your legal team will be able to review and determine if those security deposits can be recouped or applied toward what you owe, so your lessors are not hassling your management team after the bankruptcy protections have been put into place. Logistically, coordinated, timely equipment surrender means that your administrative expense claims do not pile up against your estate.
Unsecured Business Credit Cards and Operating Lines of Credit
When earnings take a hit, business credit cards and lines of revolving credit can be used to keep your cash flow afloat and to purchase inventory. These credit balances can rapidly accumulate when your business is in serious financial straits. Any debt incurred using a credit card or line of credit is eliminated from the company's books when the company goes bankrupt. If your company gets liquidated, any amount you borrowed from a credit card or line of credit solely in your business name is canceled as a general unsecured debt under 11 U.S.C. § 501 and 502. But banks and credit card issuers nearly always require a bank owner's personal guarantee when opening a bank account.
In the case of a personal guarantee, which is usually paid by your personal bank accounts and personal assets if the bank has signed, the bank can bypass the corporate bankruptcy and ask you to pay from your own resources.
A legal discharge from the corporation does not discharge the guarantor's contractual responsibility under state law until the guarantor files their own bankruptcy case and is discharged. Reviewing the original credit documents will allow you to determine if you personally signed this secondary risk.
Customer Deposits and Unfulfilled Service Obligations
If your business had taken advance payments, made payments of deposits, or paid project retainers for products or services that you were unable to provide due to financial difficulties, those funds would be considered unsecured debts.
Customer deposits are granted unsecured priority status up to the statutory cap outlined in 11 U.S.C. § 507(a)(7). This means that on a day-to-day basis, some funds for the everyday client are returned before any money can be paid to general creditors. Any amounts deposited above the priority limit are considered a regular unsecured debt and are discharged in bankruptcy.
When you compile a complete list of all the money that has been deposited with your clients, you will ensure the court notifies your entire client base. In practical terms, it means good communication with customers about impending bankruptcies reduces conflict litigation and preserves the debtor's professional reputation.
Civil Legal Judgments and Breach of Contract Lawsuits
A conflict over your business transactions often escalates into a lawsuit, and you can end up with a judgment against your company for breach of contract or for failure to pay a bill. Bankruptcy offers strong protection and means to avoid these lawsuits and to remove judgment liens. If a creditor prevails in a civil action against you or your business, they may be able to freeze the bank accounts or take the business property.
As soon as you file for bankruptcy, the automatic stay is in effect immediately under 11 U.S.C. § 362. Section 362(a) in general bars any judicial or administrative action or proceeding against the debtor that was commenced or could have been commenced before the filing of the bankruptcy case. This federal order stops all active lawsuits, collection calls, wage garnishments, and property seizures.
No more money or legal action against you from creditors allows you to breathe and catch up with your finances and your next steps. In practice, any creditor action taken in violation of the automatic stay may be set aside by the bankruptcy court, and debtors may recover actual damages, costs, and attorneys' fees.
Altering the automatic stay is just the first step in achieving full financial relief. You must also address any active litigation and judgment liens. A judgment lien is created if a creditor entered a judgment against you before filing for bankruptcy.
In the case of a sole proprietor or individual filer, 11 U.S.C. § 522(f) allows the debtor to avoid a judicial lien on an interest in property to the extent that this lien prevents the debtor from obtaining an exemption. When you pay these liens, your creditors will be unable to take your property after your bankruptcy case is over. Strategically, filing a formal motion to prevent liens during the case avoids difficulties when clearing property titles after discharge.
Unpaid Payroll Taxes and Trust Fund Recovery Penalties
The government has strict rules for paying state tax revenues, while bankruptcy will cancel many commercial debts. Knowing what payroll taxes are will help you avoid unwelcome personal liabilities. Business bankruptcies can sometimes work for corporate income taxes if strict timing rules are satisfied, but with payroll taxes, it is a different story.
If you withhold income tax and Social Security contributions from your employees' paychecks, but you do not pay them to the government, they are known as trust fund taxes because you withheld them for your employees.
Payroll taxes that have not been remitted are given a "high priority" status and are not dischargeable in a bankruptcy case under sections 507(a)(8) and 523(a)(1) of the Bankruptcy Code. They will not be eradicated by corporate bankruptcy. Tax agencies have broad powers to seize remaining corporate assets until the full amount of those taxes has been paid. Statutory trust fund tax priority rules are not discretionary, either by the IRS or the California Franchise Tax Board.
In addition to the exposure on a corporation's balance sheet, unpaid payroll taxes pose significant personal risks under Internal Revenue Code Section 6672 (26 U.S.C. § 6672). Any person who is required by this title to collect, to keep the books and records for the truthful accounting, and to pay over any amount of tax imposed by this title, which fails to collect such tax for willful failure, shall be liable to a penalty of not less than the total amount of the tax so evaded. The IRS can reach any business owner, officer, or manager who could have paid taxes and failed to do so through the corporate shield to assess this Trust Fund Recovery Penalty. This will result in your personal liability for 100% of the tax obligation of a company's unpaid employees, even after the company has ceased to exist.
Working with experienced counsel helps you address tax arrears, negotiate payment options, or explore personal bankruptcy filings if your personal assets face immediate IRS action. The most important defense against 6672 assessments is to show a lack of decision-making authority or a lack of willfulness.
Debts Incurred Through Corporate Fraud, False Statements, or Larceny
Federal bankruptcy laws are designed to provide relief to honest business owners who, in adverse circumstances, were victims of adverse market conditions, but not to those engaged in intentional wrongdoing.
A discharge under Section 727, 1141, 1228(a), 1228(b), or 1328(b) of the Bankruptcy Code does not discharge an individual debtor from any debt for money, property, services, or extension or renewal or refinancing of any credit, except to the extent secured by an assignment, legal mortgage, or other involuntary lien. Under 11 U.S.C. § 523(a)(2), creditors can contest the discharge of debts incurred through false financial statements or fraud by filing formal adversary proceedings in bankruptcy court.
Similarly, debts of money lost due to theft or foolish spending cannot be wiped away. These financial schedules must be prepared in a complete, honest, and accurate manner to protect your legal rights and avoid serious consequences. Creditors with the burden of proof under Section 523(a)(2) will be required to prove fraudulent intent by a preponderance of the evidence.
Government-Backed Small Business Loans With Personal Guarantees
When times are tough, many business owners turn to Small Business Administration (SBA) loans or Economic Injury Disaster Loans (EIDL). These programs provide useful capital but are subject to federal rules. Federal lending guidelines virtually always call for a personal guarantee, even if a loan is issued to your business. If your business fails or goes bankrupt, the government or the lending bank will demand full repayment from your personal savings and personal property, and it will do so quickly.
Under federal common law and SBA regulations, a principal corporate obligor's release in bankruptcy does not discharge the contractual obligations of a personal guarantor. When your SBA loan is in default, you need to be careful and plan your settlement with the lender or plan for a personal bankruptcy to avoid having the federal government destroy your personal finances.
If you are seeking to work with the SBA Office of Hearings and Appeals or other mitigation strategies like the Treasury Offset Program, you must do so at the outset of default or when the situation is just starting to go wrong.
Call a Professional Bankruptcy Attorney Near Me
Successfully discharging trade debts, managing commercial leases, and evaluating credit lines. Addressing non-dischargeable liabilities, such as payroll taxes, is critical to managing commercial debt and determining which liens are acceptable for discharge in a federal bankruptcy case. If you are facing a corporate liquidation or personal liability exposure, it is best to seek legal advice before taking any action or risking compromising your financial position and losing your assets to creditors.
Los Angeles Bankruptcy Attorney offers extensive experience and strong representation for entrepreneurs and businesses seeking financial relief. Our firm works through complex balance sheets, resolves personal guarantees, and protects your interests in bankruptcy. Do not let debt become a problem for your business. Call our office today at 424-285-5525 to set up a confidential appointment.
