The economic duress unleashed by the global pandemic has attorneys scrambling to meet an expected surge in bankruptcy cases. While CPAs may not be directly involved in preparing bankruptcy petitions and handling the legal aspects of cases, they are likely to be immediately affected, whether working as a chief accounting officer or in some other leadership position for a business or serving clients in practice. For accountants, bankruptcy issues can arise because of a company's or individual's own financial distress or because a company's customer appears to be headed for insolvency. In either case, CPAs will probably be sought out for advice.
This article examines some basic bankruptcy issues that are likely to arise as CPAs manage the economic challenges caused by COVID-19. While not intended to supplant the role of legal counsel, this article offers observations and guidance that may help CPAs navigate bankruptcy cases and better partner with clients, colleagues, and attorneys in bankruptcy matters.
MY CLIENT HAS FILED BANKRUPTCY. WILL I BE PAID?
The question of payment is an obvious issue for CPAs in practice. Accountants can be hired, with court approval, by debtors, bankruptcy trustees, and Chapter 11 creditor or equity security holder committees. Fees for work done by the CPA as part of the bankruptcy qualify as administrative expenses. Administrative expenses are entitled to payment priority from estate assets (11 U.S.C. §507(a)(2)). In a Chapter 7 case, which is a liquidation proceeding, this means the CPA will share in any assets that may be left after secured creditors take their collateral or are otherwise satisfied and any claims associated with domestic support obligations (if the debtor is an individual) are paid (11 U.S.C. §507). Practitioners need to consider the risk of not being compensated, in whole or part, before accepting Chapter 7 bankruptcy estate work. While a position as a priority creditor in a Chapter 7 bankruptcy makes payment more likely, it is not certain.
During a Chapter 11 reorganization (typically used by corporations), a CPA can expect to be paid for bankruptcy services as the case progresses. In order for a court to confirm a plan of reorganization, the plan must provide that professional fees and other allowed administrative expenses will be paid on confirmation of the plan, except to the extent that the holder of a claim for these expenses has agreed to a different treatment of the claim (11 U.S.C. §1129(a)(9)).
Chapter 13, which provides for individual reorganizations if debts are below certain thresholds, also requires full payment of priority debts such as administrative expenses, but the payments can be in deferred cash; the plan is not required to pay post-petition interest (11 U.S.C. §1322(a)).
The possibility of significant payment is much more tenuous when a CPA in practice seeks compensation for work that was done earlier and not as part of the bankruptcy filing. In these cases, the amount owed will most likely be general unsecured debt. In Chapter 7 this debt is paid only if assets remain after the secured creditors receive payment or other satisfaction and distributions are made to those holding priority obligations (11 U.S.C. §726(a)). Similarly, some or most prepetition fees owed a CPA by Chapter 11 or Chapter 13 clients are likely to go unpaid. This means it is important to monitor receivables due from clients and take steps to keep accounts reasonably current regardless of the type of bankruptcy that may be anticipated.
There is a further concern involving fee payment. The Bankruptcy Code allows the bankruptcy estate to recover "preferences," which are payments or transfers made on old debt within 90 days before a bankruptcy filing (or within one year for insiders), where the creditor receives more than it otherwise would have in a Chapter 7 liquidation (11 U.S.C. §547). The bankruptcy trustee, or the debtor in a Chapter 11 case, can claw back these payments or transfers. Preferences can apply in both liquidation and reorganization cases. No preference exists if the transaction is a transfer in the ordinary course of business, like a routine payment for utilities provided the previous month, or a substantially contemporaneous exchange for new value (11 U.S.C. §547(c)).
In Trauger, a bankruptcy trustee recovered as preferential transfers fees that were paid to an attorney for professional services (In re Trauger, 105 B.R. 120 (Bankr. S.D. Fla. 1989)). The bankruptcy court held that all payments necessarily were for past services since none of the attorney's statements were ever paid in full and balances were carried over to each following month, and therefore the payments were preferences and could be clawed back. As the outcome of this case suggests, where a client is in arrears and bankruptcy may be looming, the practitioner should insist on current payment for any new services performed, to try to qualify the transaction as a substantially contemporaneous exchange for new value. Further, as noted below in more detail, payments should be applied to the most recent payable to minimize preference exposure.
A final point regarding payment of fees is that a professional working in a bankruptcy matter must file a verified statement of all connections with parties in interest. This is to ensure that the CPA does not have a disqualifying conflict of interest. Thus, CPAs seeking to be retained in a bankruptcy matter who are owed monies from services performed prepetition and hold unsecured claims, or who have received payments that may be considered preferential, will need to consider the waiver of the claim and the disclosure of the potential preference amounts in a retention certification.
WHAT STEPS CAN A BUSINESS TAKE IF A CUSTOMER MAY BE BANKRUPT?
The key advice for a business whose customer may be bankrupt is to check the documents pertaining to the transaction. Unless there is an outstanding blanket purchase order or purchase contract, a seller is under no obligation to give open shipment terms, meaning that the seller can switch at any time to cash on delivery (COD), cash before shipment (CBS), or cash in advance (CIA). Another option when there is no current order or contract is for a seller to insist on a signed financial statement regarding the customer's finances. If the statement is false, the signing party may be subject to claims of fraud, which are not dischargeable in bankruptcy (11 U.S.C. §523(a)(2)). In addition, a signed statement may enhance the rights held by the seller under Uniform Commercial Code (UCC) Section 2-702, which allows a seller to reclaim goods a buyer receives on credit while insolvent (see also 11 U.S.C. §546(c)).
The UCC provides sellers of goods other protections, too. Under UCC Section 2-609, a seller has the right to demand adequate assurance of performance if reasonable grounds for insecurity exist. As for what constitutes reasonable grounds for insecurity and what assurance might be expected, a business should check with legal counsel. Failure to provide assurance within a reasonable period allows a business, under UCC Section 2-610, to suspend its own performance and pursue breach remedies. A business could insist on receiving personal guarantees from the buyer's principals, either as adequate assurance in a UCC case (UCC §2-609, comment 4) or as a condition to further shipments where no contract obligation exists. A business needs to carefully consider the value of any guarantees offered, however, as it is possible the principals of a distressed customer are also facing financial difficulties.
Timing matters. For example, if a debtor receives goods 20 days or less before filing for bankruptcy, the debt owed for them may be eligible for priority as an administrative expense (11 U.S.C. §503(b)(9)).Again, however, remember that priority treatment does not assure actual or timely payment. In addition, because of the preference rules discussed earlier, where possible, payments received from a troubled buyer should be applied to the most recent transactions, rather than old obligations (11 U.S.C. §547). A seller can decide how to apply a remittance, even if the amount matches a specific invoice, so long as the buyer does not exercise its option to designate application of payments. Analogizing this to inventory, this means the seller should use a last-in, first-out (LIFO), not a first-in, first-out (FIFO), approach to payments to help defeat a preference argument.
There are other considerations for creditors on the receiving end of a bankruptcy, too. Landlords have some unique concerns and should immediately obtain legal representation. Creditors should be sure to file a proof of claim to assert the monies they are due and any priority or collateral to which they may be entitled. Service on the creditors' committee may accord the creditor an opportunity to assist in maximizing the recovery by unsecured creditors. In addition, a creditor should evaluate exposure to preference claims and obtain information relevant to defending these actions, as a significant amount of time could pass before a claim is asserted.
Creditors who provide unique or difficult-to-source goods may be able to be certified by the court as a critical vendor. Critical vendor status will allow a vendor to continue the preexisting relationship with the debtor and be paid on prepetition obligations.
One last piece of advice is that sellers or suppliers should stay alert to any specific legislation that might cover them. One example of this is the Perishable Agricultural Commodities Act (PACA), 7 U.S.C. Sections 499a—499t, which offers many benefits to sellers of "unprocessed or minimally processed fruits and vegetables," including obtaining payment ahead of secured and priority creditors and protection from preference arguments ("PACA Claims and the Bankruptcy Code — Getting Paid Has Never Been So Easy," American Bankruptcy Institute Journal (June 2000)). Other examples of statutes helpful to businesses attempting to collect from insolvent customers include state mechanics lien laws, which may permit perfection of a lien even after the filing of a bankruptcy petition that otherwise would limit the collection activities creditors can pursue.
CAN A FINANCIALLY TROUBLED BUSINESS CONTINUE TO PAY ITS SUPPLIERS WHILE NOT PAYING PAYROLL TAXES OR SALES TAX?
With the penalties and interest imposed, it is never a good idea to fail to timely pay taxes. But in the case of payroll taxes withheld from employees or sales tax collected from customers, nonpayment can lead to personal civil or criminal liability.
When a business collects taxes from others, such as withholding income taxes or Social Security taxes from employees, but fails to remit those taxes to the federal government, the "responsible persons" of that business are subject to a penalty under Sec. 6672 of the Internal Revenue Code equal to the amount of tax not paid. Often referred to as the "100% penalty," this may be imposed on officers, owners, employees, and others who willfully fail to remit the withheld taxes. State law may provide a similar penalty for state payroll taxes (see, e.g., N.Y. Tax Law §685(g)).
A good candidate for imposition of the 100% penalty is a person, such as a CPA making payment decisions while managing a tight cash flow, who pays the client's suppliers while knowing or acting in reckless disregard of the business's failure to remit withheld payroll taxes to the IRS or a state tax authority. This is true even if the individual pays creditors at another's direction. For example, in Greenberg, 46 F.3d 239 (3d Cir. 1994), a controller who paid creditors knowing his company owed payroll taxes was found liable for the Sec. 6672 penalty, despite the fact that he had been instructed to do so by the CEO and feared losing his job.
In addition, there can be criminal liability because willful failure to remit withheld payroll taxes is a felony under Sec. 7202. In recent years, the IRS has been increasing criminal enforcement in cases of employment tax noncompliance, which can result in a fine of up to $10,000, up to five years imprisonment, or both. For a more thorough discussion of employment tax prosecutions, see "Employment Tax Penalties: Let's Keep It Civil," The Tax Adviser, Feb. 2018.
Certain strategies can help protect against the 100% civil penalty mentioned above. The penalty applies only to the withheld, or trust fund, portion of payroll taxes, including personal income tax withheld from employees' wages and the employee portion of FICA (Federal Insurance Contributions Act) taxes. By contrast, the 100% penalty does not apply to FUTA (Federal Unemployment Tax Act) taxes and the employer's share of FICA. To avoid or reduce the amount of any potential Sec. 6672 penalty imposed against responsible persons, an employer can direct the IRS to apply any voluntary partial payment of payroll taxes to the trust fund portion of the tax due, per the guidance found in Rev. Proc. 2002-26. To accomplish this, it should suffice to put an endorsement on the check to the IRS (on the top of the reverse side) saying, "Apply to only the trust fund portion of Form 941 for ___ quarter of 20__." In the absence of such directions, the IRS will apply partial payments as best serves its interests.
Beware, too, of penalties for failing to remit sales tax. In some cases, state law may hold company officials personally liable for nonpayment of state sales tax required to be collected from customers and remitted to the state tax authority. This is the rule in New York (N.Y. Tax Law §1133(a)) and various other states, including Massachusetts, Missouri, New Jersey, Ohio, and Texas (see 67B Am. Jur. 2d Sales and Use Tax §211). As is the case with federal trust fund taxes, nonremittance of sales taxes may also lead to criminal tax consequences in some jurisdictions (see, e.g., N.Y. Tax Law §§1800 and 1801(a)(5)). Given the potential for personal civil and (increasingly) criminal exposure, sales tax is also a dangerous candidate for funding a financially troubled business.
IF A BUSINESS CLOSES ITS DOORS AND LIQUIDATES ITS ASSETS, DOES IT HAVE TO FILE FOR BANKRUPTCY?
A company that is in liquidation, meaning it is ceasing operations and liquidating its assets, is not required to file a bankruptcy petition. Further, it is not likely to benefit from a bankruptcy because of the high costs of filing and because only individuals, not corporations, are eligible for discharge in a Chapter 7 liquidation. Nor would Chapter 11 normally be helpful in these circumstances because a company that is already liquidating is ineligible to receive a discharge under that chapter (11 U.S.C. §1141(d)(3)(A)).
A company that is liquidating likely will address its secured creditors outside of the bankruptcy process, perhaps through an arm's-length sale of the collateral or other means. The inability to pay creditors in full, whether secured or unsecured, does not require it to file a bankruptcy petition. A filing may be beneficial if a company has potential clawback claims, like preferences, that could be asserted in bankruptcy. Even where clawback claims exist, however, a company may find it advisable not to file a bankruptcy petition, especially if payments discharging personal guarantees might also be reversed.
WHAT ADVICE CAN A CPA GIVE ABOUT WHICH BILLS TO PAY?
Whether bankruptcy looms as a possibility or a certainty, accountants are often asked for advice about whom to pay and, further, for help trying to win concessions from the creditors whom they have recommended receive payment. CPAs often excel at negotiations, but the decision as to which obligations to satisfy must be made with great care. Relevant considerations include which debts are nondischargeable, meaning they will survive a bankruptcy proceeding, and which creditors may be important to the future prospects of the business or its principals.
Timing also matters, since payments made on old debt too close to a bankruptcy filing may be overturned as a preference, as discussed previously. CPAs should work closely with counsel when developing a payment strategy for a financially troubled business, because plans that would otherwise be sound could actually be disadvantageous due to bankruptcy rules.
Because of COVID-19, the topic of bankruptcy is likely to be part of many conversations CPAs will have for the foreseeable future, either with clients or principals of a business where the CPA serves in a leadership role. CPAs who assist in a liquidation or reorganization may be called upon to work closely with legal counsel to prepare the necessary financial information. Beyond that, however, CPAs may find themselves fielding basic questions about bankruptcy, either because of a worsening financial situation or because of urgent financial straits a business's customer is facing. While being careful not to practice law and remaining watchful for their own economic security, CPAs nonetheless can add value to their professional relationships by being familiar with bankruptcy issues such as those discussed in this article.
About the authors
Arlene M. Hibschweiler, J.D., MBA, is a clinical associate professor, and Martha L. Salzman, J.D., is a clinical assistant professor, both in the Accounting and Law Department at the University at Buffalo School of Management. Timothy P. Lyster, J.D., and William F. Savino, J.D., are both partners at Woods Oviatt Gilman LLP in western New York.
To comment on this article or to suggest an idea for another article, contact Dave Strausfeld, a JofA senior editor, at David.Strausfeld@aicpa-cima.com.
- "New Options for Small Business Bankruptcies," CPA Insider, March 30, 2020
- "Employment Tax Penalties: Let's Keep It Civil," The Tax Adviser, Feb. 2018
- "How to Help Clients Who Are Considering Bankruptcy," May 8, 2020, AICPA Personal Financial Planning Section
- AICPA CFF Exam Review Course (#164333, online access)
- Bankruptcy, Insolvency and Reorganization (#159960, online access)
- Bankruptcy — Part 1 and Part 2 (#167010, online access)
- Fundamentals of Forensic Accounting Certificate Program (#159950, online access)
- Specialized Forensic Accounting Certificate (Course + Exam) (#167110, online access)
For more information or to make a purchase, go to future.aicpa.org/cpe-learning or call the Institute at 888-777-7077.
FVS Section and ABV and CFF credentials
For AICPA members, membership in the Forensic and Valuation Services (FVS) Section provides access to specialized resources in the forensic and valuation services discipline areas. Visit the FVS Center at aicpa.org/FVS. Individuals with a specialization in business valuation may be interested in applying for the Accredited in Business Valuation (ABV) credential, and individuals with a specialization in forensics may be interested in the Certified in Financial Forensics (CFF) credential. Information is available at aicpa.org/credentials.