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Insolvency is always a tough test for both business owners and their employees, as well as for investors and business partners who are stuck with outstanding invoice obligations. However, insolvency proceedings don’t always have to mean the absolute worst. Unlike liquidation, which aims to completely dissolve a company, insolvency proceedings give business owners the chance to revamp their company. The main objective is to settle outstanding payments during ongoing operations and ensure that the company continues operating (possibly with new owners).
- What is insolvency? Definition and explanation
- Possible reasons for insolvency
- When is a company considered insolvent?
- Standard insolvency proceedings
What is insolvency? Definition and explanation
The term insolvency is derived from the Latin word solvere and refers to the state of a company or individual that is unable to settle outstanding payments because its expenditure can no longer be covered by its revenue. This can happen because of a company making a misinvestment, misjudging business risk, or making errors in price calculation. However, general market changes or an economic crisis can also drive a company into insolvency.
Insolvency is the imminent financial collapse of a company or private individual. It is characterized by the fact that debts or liabilities to creditors can no longer be settled at present or in the near future. The reason for this is that the necessary expenditures permanently exceed the (expected) revenues.
The US Bankruptcy Code distinguishes between different cases of insolvency, each subject to certain conditions:
- Insolvency for corporations, partnerships, and sole traders.
- Consumer insolvency (including private insolvency) for natural persons (private individuals) and the formerly self-employed who have low debt burdens and no existing claims from previous employment periods.
Possible reasons for insolvency
A company’s insolvency can be caused by internal and external factors. Internal factors include anything that is the responsibility of management or planning errors, such as:
- Production costs were estimated too low.
- Insufficient funding was secured.
- The company has expanded too extensively.
- Important internal company processes were poorly organized or manipulated.
When it comes to external factors, a company can go bankrupt through no fault of its own. This could happen, for example, as a result of an economic crisis, or if important customers or business partners become insolvent and outstanding claims are not adequately settled.
The latter often affects companies that are highly dependent on subcontractors and/or imports of raw materials, like construction and manufacturing.
However, an industry-by-industry view of corporate insolvencies in North America in 2018 shows that the top three sectors for insolvencies are construction, retail, and agrifood businesses. Manufacturing industries occupy the lower ranks in the insolvency list. Retail insolvencies appear to be fairly common because a lot of start-ups and small businesses are in this sector, which increases competitive pressure. Additionally, business owners’ lack of experience can make new companies particularly vulnerable to poor planning.
When is a company considered insolvent?
There are several tell-tale signs that a company is heading for bankruptcy. For example, if the company requires regular private contributions from the business owner’s private funds, the credit limit is regularly increased, payments are delayed over a long period of time, and idler time in production occurs, savings are quickly depleted on new acquisitions and personnel costs. These are clear indications of impending insolvency.
Officially, a company is not considered insolvent until insolvency proceedings have been initiated. To do this, at least one of the three following reasons must apply:
- The company is unable to meet its payment obligations.
- The company is not expected to be able to meet payment obligations when they become due.
- The amount of existing liabilities exceeds the amount of an enterprise’s total assets.
Ways to avoid insolvency
The looming possibility of a company’s insolvency does not necessarily have to result in insolvency proceedings. Beforehand, negotiations with creditors will examine whether insolvency can be avoided.
Possible ways to avoid insolvency include:
- Canceling debts (either the total amount or through installments)
- Extension of payment deadlines
- Agreement on installment payments (this is particularly useful if the company is only temporarily experiencing payment difficulties and they expect their situation to improve shortly).
- Inclusion of a partner who can make a private contribution to the company.
In any case, it is important for business owners to deal with any financial difficulties in their company as quickly as possible, and explore all possible solutions. If the managing director of a company ignores payment difficulties for too long or deliberately conceals them, you could be held liable for procrastinating your insolvency proceedings. If insolvency proceedings are filed too late, the company can be punished with fines or even imprisonment.
Standard insolvency proceedings
Insolvency proceedings include the following steps and are strictly regulated at the federal and state level. Please consult a financial consultant to ensure that you are within the remit of the law when undertaking insolvency proceedings.
Step 1: Recognition of insolvency proceedings
As soon as the creditor or debtor considers the requirements for insolvency fulfilled, they can request that insolvency proceedings begin. This application is then examined by a judge or an expert appointed by the court.
The court examines whether a company has enough remaining funds to finance the settlement of debts required in the insolvency proceedings. If this examination ends positively, insolvency proceedings are launched. If the necessary conditions for insolvency are not met, an opening decision is issued publicly.
Step 2: Appointment of an insolvency administrator
As soon as insolvency proceedings are opened with a public announcement from the court, an insolvency administrator is appointed. The administrator directs and supervises all the necessary steps and coordinates with the business owner on the course of action so that all parties involved can benefit. In particular, the insolvency administrator tries to secure and preserve the company’s assets. The insolvency administrator determines the company’s exact debt burden and its insolvency assets, i.e. the assets available to settle the debts in the context of insolvency proceedings.
Step 3: Convening the creditor’s meeting
All creditors are invited to report within a predetermined period and to disclose their claims. On the basis of the situation just determined, a decision is made as to how all debts can be settled as fairly as possible and whether a restructuring of the company is possible. The decision will be taken at a creditor’s meeting, after the insolvency administrator has disclosed the company’s economic situation.
Step 4: Settlement of current business and distribution of assets
The next step is to conduct the company’s open business. This means that all existing contracts will be reviewed, and the resulting obligations examined. Here, the insolvency administrator decides in cooperation with the contracting parties, whether remaining contractual services can be provided or the contracts (possibly with severance payments from the insolvency estate) are dissolved.
The insolvency administrator liquidates the insolvency assets into money, which can then be distributed to the creditors. Exploitation may be carried out by selling or auctioning off assets or equipment such as production machinery.
If the company is sold to a new owner, the proceeds from the sale will also be included in the insolvency estate.
Special situation: Insolvency plan proceedings
If there are positive indications that the company might survive, the law offers the option of insolvency plan proceedings that result in the company staying afloat. The advantage is that individual regulations can be defined in an insolvency plan that deviates from the legal requirements for a regular insolvency situation.
To facilitate this, all parties involved in the insolvency proceedings jointly draw up an insolvency plan, which is then subject to legal review. Subsequently, the creditor’s meeting will vote on the plan, and in the event of a positive outcome, the court will confirm the official insolvency plan. Once completed, the plan becomes final and the rules set out therein are binding to all parties.
This type of insolvency proceeding usually aims to facilitate the maintenance and successful continuation of a company.
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