How Your Business Structure Matters in Bankruptcy

As a business owner considering bankruptcy, the structure of your business - sole proprietorship, partnership, LLC, or corporation - affects the options you have.

Bankruptcy solves many problems facing struggling businesses. However, since not all bankruptcies are right for all businesses, a bankruptcy outcome depends upon whether the business is a sole proprietorship, a partnership, or a corporation/limited liability company (LLC), and understanding these differences is key to achieving the result you’re looking for.

(For an overview of each of these types of business bankruptcies, see Bankruptcy for Small Business Owners: An Overview).

Types of Bankruptcies

Depending upon the overall health of a company, business bankruptcies can help struggling businesses in one of two ways. Here is a quick explanation of the options under specific chapters:

Chapter 7. When there is no chance of salvaging the business, this chapter allows the business to close in a transparent manner. While any business can use this chapter, it isn’t always the best choice, as you’ll find below.

Chapter 13 and Chapter 11. These chapters help businesses stay open by allowing them to make smaller monthly payments to creditors. The type of business determines which Chapter the business can file (Chapter 13 is significantly cheaper than Chapter 11).

The Sole Proprietor

As a sole proprietor, you and your business are one-in-the same, which, in a nutshell, means that you are responsible for all of the business debts. Because of this, both your personal and business finances are part of the bankruptcy and you must include all your assets and debts -- both personal and business – when you file. You cannot exclude anything.

Chapter 7. There are two primary benefits to this chapter. First, it wipes out all of your dischargeable debts without the need to make ongoing payments (including your personal responsibility to pay business debt). Second, you can keep, or "exempt," both business and personal property up to the dollar amount allowed by your state. The trustee sells anything over and above that amount and gives the proceeds to your creditors.

Chapter 13 or 11. You also have the option of filing either a Chapter 13 (which is preferred if you meet filing guidelines because it doesn’t cost as much) or a Chapter 11. Both chapters allow a business to stay open if it makes enough money to continue running while paying a reasonable amount to creditors each month. The bottom line is that if the business doesn’t make money, these chapters won’t help.

The Partnership

Partnerships are trickier, and often bankruptcy doesn’t provide much relief. In fact, a business bankruptcy can be financially harmful to individual partners if not careful.

Chapter 7. Many people are surprised to learn that a Chapter 7 bankruptcy doesn’t discharge business debt. It simply allows the trustee to sell business assets and pay off creditors. Since partners remain liable – meaning debts don't go away unless paid -- the bankruptcy trustee can (and will) come after the personal assets of the partners for the purpose of paying creditors. A way around this may be for the individual partners to file Chapter 7, but this isn’t always feasible.

Chapter 11. Since a partnership cannot file a Chapter 13, if the business wants to remain open, its only option is to file a Chapter 11, which is a costly process.

The Corporation or LLC

Corporate bankruptcies have additional hurdles to scale before any filing can take place. For example:

  • A corporation or limited liability company (LLC) must retain an attorney to file on its behalf; and
  • The bankruptcy can only be authorized by someone with authority to do so (which may be difficult if officers have abandoned the corporation).

Chapter 7. The best reason for filing a Chapter 7 is to assure creditors that all of the business assets are actually being sold and used to pay debt. Since it's the trustee’s job to liquidate business assets and disperse the funds to creditors, a Chapter 7 can streamline the wind down process in a transparent manner that can help prevent future fraud lawsuits. However, while the corporate entity generally shields shareholders from responsibility for corporate debt, bankruptcy can also provide an easy forum for a creditor to shift the debt to the shareholders through alter ego litigation.

Chapter 11. Sometimes a corporation or LLC has a good stream of income, it just can’t meet all of its obligations each month. In such a case, a Chapter 11 is an option because it allows the company to pay a smaller, more manageable amount. The main problem is that Chapter 11 is expensive and complicated – too expensive, in fact, for many smaller businesses.

Chapter 13. Corporations may not file a Chapter 13 bankruptcy.

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