Filing a Chapter 7 bankruptcy can be a smart strategy for a small business, especially for a sole proprietor who, in some instances, can keep a business open after bankruptcy. But for partnerships and corporate entities, the pitfalls that come with Chapter 7 often outweigh its primary benefit—that of the Chapter 7 bankruptcy trustee selling business assets and distributing the proceeds to creditors.
To avoid adverse outcomes, business owners and stakeholders often forgo putting the business itself in Chapter 7. Instead, many choose to erase business liability and consumer debt by filing a personal Chapter 7 after a company closure.
Other bankruptcy chapters available to struggling businesses include the cheaper and easier to use Chapter 11, Subchapter V. Read Bankruptcy for Small Business Owners: An Overview for an introduction to all small business bankruptcy options.
Sole proprietors who need a fresh start often find Chapter 7 quite beneficial. It discharges (wipes out) personal and business debt in the same case. It's almost like getting two Chapter 7 bankruptcy discharges for the price of one.
A sole proprietor can discharge many debts in Chapter 7, such as credit card balances, medical bills, past-due lease obligations, utility bills, personal loans, and gym memberships, regardless of whether it's a business or consumer debt. It's even possible to discharge mortgages, car payments, and other secured debts, but you'll have to give back the property serving as collateral.
Bankruptcy doesn't erase all obligations, however. Common nondischargeable debts include most tax and support obligations, student loans, fines and penalties owed to the government, and debts incurred through fraud.
Sole proprietors don't lose everything after filing a Chapter 7 case. Unlike other business types, sole proprietors can keep property covered by bankruptcy exemptions. Exemptions vary by state but usually include necessary items needed to maintain a job and home—for instance, some equity in a house and car, household furnishings, clothing, and a retirement account. Conversely, luxury items, such as boats, recreational vehicles, or company shares, are rarely exempt.
Keeping it will depend on the type of business, and whether bankruptcy exemptions will protect the property needed for the company to remain operational. Specifically, you'll be able to keep an existing business as long as the trustee doesn't sell a vital part of the company or the company itself.
The trustee can't sell your future services. If your business is a service-only operation, and you're the person supplying the service, you won't lose it. For instance, a gardener, nanny, or lawyer, would be able to continue providing business services. Some trustees will require proof of liability insurance, however.
The trustee can sell products, equipment, a contact list, and goodwill. To keep these things, you'll need to be able to protect them with a bankruptcy exemption. Most states let filers keep some property required to operate a business using a "tools of the trade" exemption. If it isn't enough, a wildcard exemption might cover an additional amount. Not all states have wildcard exemptions, however, and the value and type of property it will protect can vary.
You're likely worried about losing property in Chapter 7, and it could happen—the trustee sells assets regularly in small business cases. But that's not the critical question. You'll want to determine whether you'll receive an overall financial benefit. Specifically, if the total amount of discharged debt would somewhat significantly exceed the value of the property you'd lose, filing could make sense. If, however, you'd repay everything you owe in Chapter 7, you might have better success negotiating your debt directly with creditors.
For example, suppose you have $200,000 in total debt that you'd like to discharge and the following in assets:
With over $1 million in personal assets, it wouldn't make sense to file bankruptcy because the trustee in virtually all states—check your state's exemptions—would sell the majority of your property at fire-sale prices to cover your $200,000 debt load. Plus, trustees get paid for selling property, so you'd lose a hefty percentage to the trustee.
If you have substantial valuable assets and decide that filing Chapter 7 won't work for you, you should assume that creditors will come collecting soon. Being proactive and initiating a debt settlement for less than what you owe could be a good idea. If successful, you'd likely need to sell some property to satisfy the negotiated debt. But you can save money there, too. Not only will this approach avoid the added cost of the trustee's fee, but you'd likely be able to hold out for a higher price and get more than the trustee would be able to at an auction-type sale.
Debt settlement or bankruptcy lawyers can work with creditors on your behalf, but as a business person, you're likely an experienced negotiator. Because debt collection methods have changed over the years, you might want to brush up on some of the newer practices.
Not everyone is entitled to a Chapter 7 debt discharge. Your income must be low enough to pass the Chapter 7 means test—but an exception exists when a business is involved in the bankruptcy case. If the business debt exceeds the consumer debt (debt for household purchases as opposed to expenses incurred with the intent to make a business profit), you'll be exempt from taking the means test and will automatically qualify for a Chapter 7 discharge.
If you're struggling with the choice of letting go of your business in favor of a high-paying job working for someone else, this benefit might help you decide. It's the only "loophole" that will allow a filer with a substantial income to wipe out debt quickly without paying into a Chapter 13 or Chapter 11 repayment plan. Because it can be tricky, consult with a business bankruptcy lawyer early in the process.
Small business owners have more paperwork to prepare before filing for bankruptcy because the Chapter 7 bankruptcy trustee will want to see both personal and business financials. The case will start once you file the bankruptcy petition and a certificate verifying that you completed a credit counseling course.
Next, you'll turn over documents to the trustee substantiating the figures provided in the petition (called "521 documents" after the code section in which the requirement appears). Plan to provide:
You'll also attend one hearing called the 341 meeting of creditors. The trustee will check your identification, ask required questions and questions specific to your petition, and allow any creditors that appear to ask questions (they rarely do, but it happens more frequently in business-related bankruptcies). If everything is in order, the trustee will conclude the hearing. Otherwise, the trustee will continue the meeting to another date.
After completing your last responsibility—taking a debtor education course and filing the certificate with the court—you'll receive a debt discharge. Learn more about the steps in a Chapter 7 case.
Because the debtor doesn't have to repay creditors through a repayment plan, Chapter 7 is quicker than other bankruptcy chapters. Most debtors receive a debt discharge after three to four months.
The case will usually close soon after the court issues the discharge, but not always. An asset case—a bankruptcy matter in which money is available to pay creditors—sometimes will remain open for up to a year after the court issues the discharge if the trustee needs time to sell real estate or if the case involves pending bankruptcy litigation. Learn more about when the court closes a bankruptcy case.
Chapter 7 bankruptcy isn't a popular choice for partnerships. In fact, it's seldom used for several reasons:
Many partnership agreements contain clauses that dissolve the partnership if one partner files for bankruptcy, so filing a personal bankruptcy while the partnership remains viable isn't usually an option.
After a partnership closure, a personal Chapter 7 can provide the relief desired. Not only could it block financial responsibility stemming from the business and former partners (if liability isn't fraud-related), but it would also allow the partner to get out from under a personal guarantee signed on behalf of the company. If you'd like to determine the viability of Chapter 7, read the section for sole proprietors above. The analysis would work in much the same way after a partnership closure.
Filing Chapter 7 can be an excellent way for a corporation to wind down a business because the bankruptcy trustee becomes responsible for liquidating business assets, such as accounts receivables, real estate, and inventory. Once sold, the trustee distributes the funds to creditors in the manner required by law. The transparency assures most creditors that they are being treated fairly—which is a good thing.
The downside is that filing for bankruptcy opens the door for creditors to complain. One common complaint is that a shareholder mishandled the corporation and treated it as its own by doing things such as paying personal bills with corporate money called an "alter ego" cause of action. In an alter ego lawsuit, the plaintiff attempts to "pierce the corporate veil" that protects shareholders from liability for corporate debt. Filing for bankruptcy gives a disgruntled creditor an accessible forum to voice its dissatisfaction and explore alternative avenues for debt payment.
Think of it this way—getting a lawsuit started takes a lot of time and energy; however, if the case is already in the court system, as it is once a bankruptcy is filed, it doesn't take much effort for the creditor to file an alter ego lawsuit.
Many shareholders find that filing an individual Chapter 7 bankruptcy after the company closes is a more effective way to get debt relief. Although it's possible to file for Chapter 7 while the corporation or LLC remains open, most states don't protect corporate shares or interest in an LLC. So unless you could protect your holdings with a wildcard exemption, the trustee would likely sell your business interest (assuming the existence of a willing buyer). You can assess whether filing a personal Chapter 7 would be in your best interests by reading "Chapter 7 for a Small Business Sole Proprietor," above.
While bankruptcy can be useful for many businesses, it's not always a good idea. Below is a list of several of the issues you should consider. There are many more; be sure to talk to an attorney if you are considering bankruptcy for your business.
No Turning Back. There is no emergency parachute in a Chapter 7 bankruptcy. Once you file, you can only dismiss it if the court allows you to—and that's not a good thing to count on. The bottom line is that once you're in, you should assume that you're in to stay. Even if you find out you can't keep property you thought was safe.
Taxes. There are countless issues when it comes to business taxes and bankruptcy. Talk to your accountant before you file so you don't end up with a surprise at the end of your case.
Certain lawsuits. The automatic stay—the mechanism that stops your creditors from continuing to collect against you after you file—only applies when you're sued for money. It won't affect criminal actions or civil enforcement proceedings, such as if the government claims your business is polluting the environment. That lawsuit will march on despite your bankruptcy, and no one wants to be questioned about the same issues twice. So keep in mind that your bankruptcy might do little more than provide a second forum the prosecutor can use for discovery purposes.
Improper purposes. The courts also don't take lightly to people filing for improper purposes, such as to stall a foreclosure proceeding, or to hide wrongdoing on the part of the business principals. Since penalties are stiff, it's best to approach the bankruptcy court with clean hands.
Bankruptcy can be a great tool when it's time to unwind a failing business or wipe out personal responsible for business debt. A business-related bankruptcy always presents more issues than the typical case, and getting sound advice is essential. Be sure to consult with a bankruptcy lawyer experienced in handling business and consumer bankruptcy early in the process.