What Happens to Shareholders When a Company Goes Bankrupt?

When a company faces severe financial distress, it may seek protection through a legal process known as corporate bankruptcy. This process allows a business to liquidate assets to pay creditors or reorganize its financial structure. Bankruptcy provides a framework to address overwhelming debt, offering a fresh start and ensuring fair distribution of remaining assets.

Types of Corporate Bankruptcy

Corporate bankruptcy typically involves two main types under U.S. law: Chapter 7 and Chapter 11. Chapter 7 bankruptcy, often referred to as liquidation bankruptcy, means the business ceases all operations. A court-appointed trustee then takes control, selling off the company’s assets to generate funds. These proceeds are subsequently distributed to creditors according to a legally defined order of priority.

In contrast, Chapter 11 bankruptcy is a reorganization process, allowing a company to continue its operations while it develops a plan to restructure its debts. Under court supervision, the company proposes a repayment plan to its creditors, often involving negotiations to reduce debt amounts, lower interest rates, or extend payment terms. This approach aims to help the business return to financial stability and profitability, rather than shutting down entirely.

How Claims are Prioritized

In any corporate bankruptcy, the distribution of a company’s remaining assets follows a strict hierarchy known as the “absolute priority rule.” This rule dictates that higher-priority claims must be paid in full before any lower-priority claims receive payment.

The typical hierarchy of claims begins with secured creditors, such as banks holding liens on specific company assets, who are paid first from the proceeds of their collateral. Following these are administrative expenses, which include costs incurred during the bankruptcy process itself, such as legal fees for attorneys and accountants, court fees, and compensation for the bankruptcy trustee.

Next in line are priority unsecured creditors, which can include certain employee wages and benefits, and specific tax claims. General unsecured creditors, such as suppliers and bondholders, come after these priority claims. Preferred shareholders follow, and common shareholders are at the very bottom of this payment structure. Unless all higher-priority classes have been fully satisfied, lower-priority claimants, including shareholders, typically receive nothing.

The Shareholder’s Outcome

Given their position at the bottom of the claims hierarchy, the outcome for shareholders, particularly common shareholders, is often unfavorable in corporate bankruptcy. In Chapter 7 liquidation cases, common stock almost invariably becomes worthless. This occurs because there are rarely enough assets remaining after secured creditors, administrative expenses, and other unsecured creditors have been paid.

In Chapter 11 reorganization, while the company continues to operate, existing equity is frequently canceled or significantly diluted. As part of a reorganization plan, new shares might be issued to creditors, who may become the new owners of the reorganized company, or to new investors providing fresh capital. Old shareholders rarely retain significant value or control, as their interests are typically wiped out or severely reduced to satisfy the claims of higher-priority creditors. While shareholders generally have limited influence in bankruptcy proceedings, they do have rights to information and can, in some Chapter 11 cases, vote on reorganization plans, though their voting power might be limited if their interests are impaired.

Tax Treatment of Worthless Stock

When stock becomes completely worthless due to a company’s bankruptcy, individual shareholders may be able to claim this loss for tax purposes. Under Internal Revenue Code Section 165, if a security that is a capital asset becomes worthless during the tax year, the loss is treated as a capital loss. This capital loss is considered to have occurred from a hypothetical sale or exchange of the security on the last day of the tax year in which it became worthless.

This capital loss can be used to offset any capital gains an individual may have from other investments. If the capital losses exceed capital gains, the excess can be deducted against ordinary income, up to a maximum of $3,000 per year ($1,500 if married filing separately).

Any unused portion of the capital loss can be carried forward indefinitely to offset capital gains or ordinary income in future tax years. To claim this deduction, taxpayers must establish that the stock truly became completely worthless during the tax year, which can be evidenced by identifiable events such as the company’s dissolution or liquidation.