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The Risks of Filing a Chapter 7 Bankruptcy for Your Company: Part 2 – Income Tax Liability

Click here to read Part 1

This is part two of three in a series covering the risks of filing a Chapter 7 bankruptcy petition for a business entity.  Please visit here to read part one.  If your business is unable to pay its debts as they come due, you would be prudent to seek the advice of bankruptcy counsel.  Bankruptcy counsel may recommend that you file a Chapter 7 bankruptcy for the company.  If you decide to close the business and file a Chapter 7 bankruptcy case, upon filing the petition, a bankruptcy estate is created, consisting of all of the company’s property and all of its debt.  A trustee is appointed to liquidate the assets, pursue lawsuits to recover money or property, and after all estate is property turned into cash, distribute the funds to creditors. 

 

 

If the company is a pass-through entity for tax purposes, the shareholders/members/equity holders may be liable for taxes due on the income generated by the trustee for the benefit of the estate.

Filing a Chapter 7 bankruptcy for a defunct business provides an orderly and transparent process for liquidating the company’s assets and distributing the funds to creditors under the supervision of the Bankruptcy Court.  There are, however, a few risks to consider as you make the decision whether to file a bankruptcy liquidation for your defunct company.  In part one, I described some of the types of lawsuits that the trustee may file to recover funds for the benefit of the estate.  Another often unexpected risk is the potential tax liability of the shareholders, members, or equity holders of the business entity for the income generated by the trustee for the benefit of the estate.

With respect to limited liability companies, some forms of partnerships, and Sub-Chapter S corporations, the filing of a Chapter 7 bankruptcy by the business entity may have income tax consequences for the equity holders.  If the trustee generates a significant amount of cash for the bankruptcy estate by selling the company’s assets and recovering money through lawsuits, that income may be taxable to the equity holders.  The bankruptcy estate generally assumes the taxpayer status of the debtor, and for those types of business entities that are “pass through” entities that do not pay income taxes, if there is tax liability for the income generated by the trustee, it falls upon the shareholders, members, or equity owners.  Even though equity holders receive no benefit from income generated by the trustee for the benefit of the bankruptcy estate, each equity holder will receive a Schedule K-1, which reports his or her pro rata share of income, gains, credits, deductions and losses, which the owners must enter on their individual 1040s to be computed and taxed at their individual tax rates.  While it is often the case that the equity holders have losses or other deductions to offset the income, the income generated by the trustee for the benefit of the estate is taxable income for the equity holders, and so if the trustee generates more income than the owners can offset with losses or other deductions, they may have to pay taxes on the estate income, even though they most likely confer no benefit from the income.

 

 

 If you have questions about the risks of Chapter 7 bankruptcy for business entities or any other bankruptcy matters, please Contact us

 

 

 

 

 

 

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