Bankruptcy Costs May Exceed the Tax Shield Benefits of Debt

Companies often take on debt to benefit from tax deductions on interest payments, which can lower their overall tax burden. While this strategy can enhance profitability, it also increases financial risk. If a company becomes too leveraged, the costs of bankruptcy may outweigh the tax savings. Balancing debt and financial stability is essential for long-term success. Excessive borrowing can lead to direct liabilities and indirect consequences that erode business value.

Interest Expense and Tax Deductions

Businesses that finance operations through borrowing can deduct interest payments from taxable income, reducing their tax liability. Under Section 163(j) of the Internal Revenue Code, interest expense deductions are generally capped at 30% of adjusted taxable income (ATI). This limitation applies to most businesses, though small businesses with average annual gross receipts under $29 million (as of 2024) are exempt.

The tax savings from interest deductions can be significant. For example, if a corporation with $10 million in taxable income before interest pays $2 million in interest expense, it can deduct that amount, lowering its taxable income to $8 million. At a 21% corporate tax rate, this results in $420,000 in tax savings. However, if interest expense exceeds the 30% ATI cap, the excess may be carried forward to future years but cannot be deducted immediately.

The effectiveness of interest deductions depends on a company’s overall tax position. If a business has low taxable income or operates at a loss, the deduction provides little immediate benefit. Additionally, tax law changes can impact this strategy. The Tax Cuts and Jobs Act of 2017 introduced the ATI limitation, and future legislative changes could further restrict or expand deductibility.

Balancing Leverage and Financial Distress

Debt provides businesses with capital for expansion, acquisitions, and operational improvements. While borrowing can amplify returns, excessive leverage increases financial risk. If debt obligations become too burdensome, a company may struggle to meet payments, leading to strained lender relationships, reduced credit access, and liquidity shortages.

A company’s credit rating influences borrowing costs. Agencies such as Moody’s and S&P Global assess financial health based on metrics like the debt-to-equity ratio and interest coverage ratio. A downgrade from investment-grade to speculative status raises interest rates on new and existing debt, making borrowing more expensive.

Investor confidence is also affected by high debt levels. Shareholders monitor leverage closely, as rising debt can signal instability. If investors perceive a heightened risk of default, stock prices may decline, making it harder to raise equity capital. Debt covenants—agreements between borrowers and lenders—often impose restrictions on financial activities. Breaching these covenants can trigger penalties, forced repayments, or legal action from creditors.

Direct Liabilities in Insolvency Cases

If a company can no longer meet its financial obligations, creditors, including banks, bondholders, and suppliers, have legal claims against its assets. Under U.S. bankruptcy law, secured creditors—those holding collateral-backed loans—are paid first, while unsecured creditors, such as suppliers or bond investors, are paid only after secured claims are settled.

Executives may also face personal liability in certain cases. If financial mismanagement, fraud, or preferential payments to select creditors occurred before insolvency, courts may hold executives accountable. Under 11 U.S.C. 547, preferential transfers made within 90 days before filing can be reversed, forcing creditors to return payments. Similarly, fraudulent transfers under 11 U.S.C. 548 can be unwound if assets were moved to evade creditors.

Tax liabilities can persist even in bankruptcy. Payroll taxes, classified as trust fund taxes under IRS regulations, cannot be discharged. The IRS can pursue company officers personally for unpaid payroll taxes under the Trust Fund Recovery Penalty (TFRP), which allows for individual liability if responsible parties failed to remit withheld employee taxes.

Indirect Stresses from Bankruptcy Filings

Beyond legal and financial consequences, bankruptcy filings disrupt business operations, employee morale, and industry relationships. Suppliers often tighten credit terms or demand cash payments upfront, increasing liquidity strain. In industries that rely on vendor financing, such as retail and manufacturing, this shift can make it difficult to restock inventory or fulfill contracts.

Customer confidence also declines sharply following a bankruptcy announcement, particularly in sectors where long-term service agreements or warranties are involved. Consumers may hesitate to purchase from a company they fear will not survive, leading to a drop in revenue. This is especially problematic for subscription-based businesses, where customer retention is a primary driver of value. Competitors often capitalize on this uncertainty, using aggressive marketing strategies to attract clients, further eroding market share.