Corporate insolvency law in the United States sits primarily in Title 11 of the U.S. Code, the Bankruptcy Code, which sets the rules for when a company is legally insolvent, how creditor collection is frozen once a case begins, and how a company’s remaining value is either preserved through reorganization or divided up in liquidation. The framework tries to do two things at once: give a viable business a chance to survive its debts, and make sure creditors get an orderly, predictable share of what is left when it can’t.
When a Company Is Legally Insolvent
The Bankruptcy Code defines corporate insolvency using a balance-sheet test: a company is insolvent when its total debts exceed the fair value of all its property, excluding anything the company transferred or hid to keep away from creditors.1Office of the Law Revision Counsel. 11 USC 101 Definitions
That is not the only test that matters. In an involuntary case, where creditors push a company into bankruptcy, courts look at whether the debtor is generally not paying its debts as they come due. That is closer to a cash-flow test, and it catches a company that looks fine on paper but cannot actually meet its obligations. A business sitting on $10 million in real estate but unable to cover next week’s payroll can be solvent by the balance-sheet measure and clearly in distress by any practical one.
Timing matters too. During the 90 days before a bankruptcy filing, the law presumes the company was insolvent.2Office of the Law Revision Counsel. 11 USC 547 Preferences That presumption drives a lot of the clawback litigation that follows a filing.
The Automatic Stay Freezes Collection
The moment a bankruptcy petition is filed, an automatic stay stops nearly all collection activity against the debtor.3Office of the Law Revision Counsel. 11 USC 362 Automatic Stay Creditors cannot start or continue lawsuits, enforce judgments, seize assets, create or perfect liens, or attempt to collect on pre-filing debts. Utility companies and the IRS are generally bound by it as well.
Without the stay, the fastest and most aggressive creditors would strip assets before the court could organize a distribution. The stay has limits. It does not block criminal proceedings, and a secured creditor can ask the court to lift it if collateral is losing value and the creditor is not being adequately protected.
Choosing a Bankruptcy Chapter
Corporate debtors generally take one of two main paths, with a streamlined third option for smaller companies. The right chapter turns on whether the business has a future worth saving.
Chapter 7 Liquidation
Chapter 7 shuts the company down. A trustee is appointed to collect and sell the company’s assets, pay creditors according to the statutory priority order, and close the business. Once the case ends, the corporate entity effectively ceases to exist. This path fits when there is no realistic path back to profitability and creditors will do better from an orderly sale than from continued operations.
Chapter 11 Reorganization
Chapter 11 lets a company keep operating while it restructures its debts under court supervision.4United States Courts. Chapter 11 Bankruptcy Basics Existing management usually stays on as the “debtor in possession” and runs the day-to-day business. A trustee can be appointed if the court finds fraud, dishonesty, or gross mismanagement, but that is the exception.
The debtor proposes a reorganization plan that spells out how each class of creditors will be treated, including who gets paid in full, who takes a reduction, and on what schedule. For confirmation, every impaired class must accept the plan, or the court can force it through under a “cramdown” if at least one impaired class has voted in favor and the plan meets certain fairness requirements.5Office of the Law Revision Counsel. 11 USC 1129 Confirmation of Plan A best-interest-of-creditors test also applies: no creditor can be forced to accept less under a reorganization plan than it would have received in a Chapter 7 liquidation.
Subchapter V for Smaller Businesses
Subchapter V of Chapter 11 offers a faster and cheaper reorganization path for companies with modest debt. To qualify, total noncontingent, liquidated debts must fall under roughly $3 million (excluding debts owed to insiders and affiliates), a figure periodically adjusted for inflation.6U.S. Department of Justice. U.S. Trustee Program – Subchapter V The $7.5 million temporary limit from the pandemic era expired in June 2024 and reverted to the lower threshold.
Subchapter V strips out some of the most expensive parts of a traditional Chapter 11. There is no disclosure statement requirement, no unsecured creditors’ committee unless the court orders one, and only the debtor can propose a plan. A standing trustee is appointed to help negotiations, but the debtor keeps control of the business. For a company with a viable core buried under unmanageable debt, this route can be the difference between a workable reorganization and a liquidation forced by the cost of the bankruptcy process itself.
Who Runs the Company During the Case
Control depends on the chapter. In Chapter 7, the U.S. Trustee’s office appoints a case trustee shortly after filing. That trustee takes over the assets, investigates the debtor’s finances, and runs the liquidation. Existing management has no further role.
Chapter 11 works differently. The debtor stays in possession and continues operating the business, essentially acting as its own trustee.4United States Courts. Chapter 11 Bankruptcy Basics A committee of unsecured creditors is typically appointed to monitor management and take part in negotiating the reorganization plan. If that committee loses confidence in how the case is being run, it can ask the court to install an independent trustee.
Shortly after filing, the U.S. Trustee also convenes a meeting of creditors under Section 341 of the Bankruptcy Code, where creditors can question the debtor under oath about its finances and the events that led to bankruptcy.7Office of the Law Revision Counsel. 11 USC 341 Meetings of Creditors and Equity Security Holders
How Creditors Get Paid
When assets are converted to cash, the Bankruptcy Code sets a strict payment order. Where a claim falls in that order usually decides how much of it gets paid.
Secured Creditors First
Secured creditors, meaning those holding claims backed by specific collateral like real estate, equipment, or receivables, generally get paid first up to the value of their collateral. If the collateral is worth less than the debt, the shortfall becomes an unsecured claim. If it is worth more, the surplus flows into the general pool.
Priority Unsecured Claims
After secured claims, several categories of unsecured claims are paid before general unsecured creditors, in a specific statutory order.8Office of the Law Revision Counsel. 11 USC 507 Priorities The main categories include:
- Administrative expenses of the bankruptcy case itself, including trustee fees, attorney fees, and expenses incurred to preserve the estate.
- Unpaid wages, salaries, commissions, and vacation or sick pay earned within 180 days before the filing, capped at $17,150 per employee as of the most recent adjustment, along with contributions to employee benefit plans for services in that same 180-day window.
- Certain federal, state, and local tax obligations owed by the debtor.
- Consumer deposits from individuals who prepaid for goods or services that were never delivered, up to $3,800 per person.
General Unsecured Creditors and Shareholders
General unsecured creditors, including trade suppliers, landlords with lease rejection claims, and bondholders without collateral, come next and share pro rata in whatever remains after secured and priority claims are paid.9Office of the Law Revision Counsel. 11 USC 726 Distribution of Property of the Estate In liquidation cases, recoveries at this level are often modest, and single-digit percentages of the original claim are common. Shareholders stand at the bottom and receive nothing unless every higher-priority claim is paid in full, which almost never happens in a liquidation.
Payments the Trustee Can Claw Back
The trustee or debtor in possession has strong tools to recover assets that left the company shortly before filing. These avoidance powers exist because companies heading toward insolvency often pay favored creditors ahead of others or move assets to insiders on the cheap.
Preferential Transfers
A preference is a payment to a creditor that leaves the creditor better off than it would have been in a Chapter 7 liquidation. The trustee can recover preferential payments made within 90 days before filing.2Office of the Law Revision Counsel. 11 USC 547 Preferences For insiders, meaning officers, directors, controlling shareholders, and their relatives, the look-back stretches to a full year before filing.
This is where trade creditors sometimes get an unpleasant surprise. A supplier who was paid on an overdue invoice a month before the bankruptcy filing may be forced to return that money, even though the payment was for goods that had actually been delivered. Defenses exist for payments made in the ordinary course of business, payments on debts incurred at roughly the same time as the transfer, and certain other transactions, but the default position is that the trustee can recover the money.
Fraudulent Transfers
Fraudulent transfer law reaches further back. The trustee can undo any transfer made within two years before the filing if the debtor either intended to defraud creditors or received less than reasonably equivalent value while already insolvent.10Office of the Law Revision Counsel. 11 USC 548 Fraudulent Transfers and Obligations Actual fraud requires proof that the debtor specifically intended to put assets beyond creditors’ reach. Constructive fraud does not require bad intent at all; it only requires that the company was insolvent and gave away value without getting fair value back.
Transfers to self-settled trusts designed to shield assets face a look-back of up to ten years. The trustee can also invoke state fraudulent transfer laws through Section 544(b) of the Bankruptcy Code, which in many states extends the reach to four or even six years before filing.
Director Duties and Personal Exposure
Corporate directors face a shifting legal picture as a company slides toward insolvency. Under normal circumstances, directors owe their fiduciary duties to the corporation and its shareholders. Once the company is actually insolvent, meaning it genuinely cannot pay its creditors in full, courts in leading corporate-law jurisdictions have held that creditors become the residual stakeholders and gain standing to bring derivative claims against directors for breach of fiduciary duty.
The practical takeaway is that directors of an insolvent company should focus on preserving enterprise value without taking outsized risks. Gambling on a long-shot pivot with creditor money is the sort of decision that invites personal liability. The duty is not necessarily to shut down immediately, but a director who keeps operating needs a defensible reason to believe the plan serves creditors as a whole.
Federal bankruptcy law gives trustees additional tools against directors who behave badly on the way down. If a trustee shows that directors knowingly kept doing business with no reasonable prospect of avoiding insolvency, the court can require those directors to contribute personally to the estate. If directors ran the business with actual intent to defraud creditors, the court can impose personal liability for the company’s debts, and directors may face disqualification from serving as officers or directors of any company.
Tax on Forgiven Debt
When a creditor forgives or writes off debt, the IRS generally treats the cancelled amount as taxable income. A company that negotiates its $2 million loan balance down to $500,000 has $1.5 million of cancellation-of-debt income that would normally be included in gross income.
The Bankruptcy Code and the Internal Revenue Code work together to soften the hit. Under IRC Section 108, a company can exclude cancelled debt from income if the discharge occurs in a Title 11 bankruptcy case or if the company is insolvent at the time of the discharge.11Office of the Law Revision Counsel. 26 USC 108 Income From Discharge of Indebtedness The insolvency exclusion is capped at the amount by which liabilities exceed assets immediately before the discharge, so a company that is $3 million underwater can exclude up to $3 million and no more.
The exclusion is not free money. In exchange, the company must reduce its future tax attributes in a specific order: net operating losses first, then general business credits, minimum tax credits, capital loss carryovers, the basis of its property, passive activity losses, and foreign tax credit carryovers.11Office of the Law Revision Counsel. 26 USC 108 Income From Discharge of Indebtedness Those reductions are reported on IRS Form 982.12Internal Revenue Service. About Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness Companies that skip this step can face unexpected tax bills years after emerging from bankruptcy.
When Operations Cross Borders
When a company with operations in more than one country fails, deciding which country’s courts control matters. Chapter 15 of the Bankruptcy Code lets U.S. courts recognize foreign insolvency proceedings.13Office of the Law Revision Counsel. 11 USC 1517 Order Granting Recognition A “foreign representative” authorized to run the foreign case files a petition in U.S. bankruptcy court, and the court classifies the foreign proceeding as either a foreign main proceeding (in the country where the debtor has its center of main interests) or a foreign nonmain proceeding (where the debtor has a place of operations). Recognition of a foreign main proceeding automatically triggers the same automatic stay that applies in domestic bankruptcy cases, protecting U.S. assets while the foreign case proceeds.
Chapter 15 is narrow. It covers insolvency, liquidation, and restructuring proceedings only. Corporate governance disputes, fraud remediation efforts, and other foreign actions that do not involve debt adjustment generally cannot obtain recognition, even if the company is in financial distress.