What To Do When a Business Fails

SPECIAL REPORT
WHAT TO DO WHEN A BUSINESS FAILS

The Step-by-Step Process for Shutting Down Operations

Small businesses are the backbone of the American economy, and while the definition of “small business” is somewhat nebulous, we all know one when we see one. Generally speaking, the IRS defines a small business as one with fewer than 100 employees or less than $10 million in annual revenue. However, the Small Business Administration has different guidelines depending on the specific industry in question. What matters for purposes of this discussion is the fluidity of small business creations and terminations.

The U.S. Census Bureau’s Business Formation Statistics gives us insight into the number of business creations and closings from year to year. Generally speaking, these data indicate that between the years 2020 and 2025 (though data lag for 2025), roughly 4-5 million new businesses per year were started. Of new business upstarts, only about 3 out of 10 last more than two years, and about 50 percent of those fail within five years.

Why do Businesses Fail?

There are a number of reasons small businesses fail. Market considerations definitely are at the top of the list. These factors include lack of demand for the goods or services offered, competition and pricing pressure from the same or similar businesses, and unanticipated costs for labor and supplies. In recent years, the COVID-19 pandemic took a massive toll on businesses due to government shut-down orders coupled with slow economic recovery because of the public’s unwillingness to quickly return to normal economic behavior.

Another key reason businesses cease operations is cash-flow and financing constraints. New businesses are often thinly capitalized and unable to get amble financing from banks or private lenders. These issues exacerbate during difficult economic times and periods of high inflation that cause unexpected increases in labor and input costs. Both of these factors piled on during the pandemic shutdowns and the supply-chain issues that materialized in the years that followed.

Other key reasons businesses fail — the reasons I most often see — are regulatory and legal challenges. These are usually brought on by federal and state tax burdens. New business owners often do not understand the myriad of tax regulations they face, especially as they relate to state and local sales taxes, and the hiring and paying of employees. In addition, businesses must increasingly deal with industry-specific regulations imposed by a laundry-list of federal, state and local alphabet-soup agencies, boards, bureaus and commissions. In this regard, there is just about no end to the list of affirmative duties placed on businesses, and these duties regularly blind-side owners.

In my book Dan Pilla’s Small Business Tax Guide, I provide detailed insight, based on over 45 years of experience representing small businesses before the IRS and in the United States Tax Court, on how to avoid tax compliance pitfalls and booby traps with the agency. But, despite my best efforts to help small businesses stay out of trouble, the reality is that businesses do fail and must be shut down.

And it’s not just a business failure that requires one to wind up operations. People retire all the time. An owner may be unable to sell a small, service-oriented business to an outsider, and thus the business just goes away. Perhaps there are no heirs willing or able to take over operations if the primary owner dies. None of these scenarios necessarily constitute a “failure” in the sense discussed above, but the outcome is the same — business operations must be terminated.

So the question this Special Report addresses is exactly what one must do to wind up operations when a business is about to shutdown. I address 15 steps and considerations necessary to accomplish that goal.

Step 1: Determine Current Financial Liabilities

To start the process, make a comprehensive list of all debts owed to creditors. This includes suppliers, business contracts (discussed further in section 3, below), bank loans and lines of credit, leases, credit cards, utilities, and unpaid wages to employees, etc.The list must include amounts owed for federal, state and local taxes and fees. These are all the current liabilities of the business.

Ascertain which of these obligations are secured, and which are not secured. A secured obligation is one that is tied to specific property that acts as collateral for the obligation. If a secured loan is not paid, the creditor has a right to take possession of the property. An example is a bank line of credit that is secured by tools and equipment, or inventory and receivables.

An unsecured loan is one made without collateral. The most common are credit card debts.

Federal and state tax debts may be secured or unsecured, depending on whether the taxing authority properly filed a tax lien in accordance with state law. An IRS lien attaches to “all property and rights to property” owned by the taxpayer as of the date the lien was filed, and attaches to all property acquired after the lien was filed. See: Internal Revenue Code (IRC) §6321.

But even if a tax debt is unsecured, it may be considered a “priority” liability, in that it must be paid ahead of other unsecured debts. For example, a liability for unpaid employment taxes withheld from the wages of employees (trust fund taxes) has priority over credit card debts even if the IRS has no current notice of lien filed on the trust fund taxes.

You will need to know the amount and character of your debts (secured or unsecured) to determine the order in which creditors should be paid upon the liquidation of company assets (if any) (discussed in section 4, below).

Steps 2- 15 are found in this special report that is part of a subscription to Dan Pilla’s electronic Newsletter.

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Check out Dan’s podcasts on this topic

How Entrepreneurs can Stay Out of Trouble with the IRS: Dan Pilla speaks LIVE