Chapter 7 Bankruptcy for a Small Business

Chapter 7 bankruptcy is often a good way for a struggling small business to wind down operations and satisfy creditors.

Filing a Chapter 7 bankruptcy is often a smart strategy for a small, failing business -- mainly because selling the business assets and distributing the proceeds to creditors becomes the responsibility of the bankruptcy trustee. However, it's important for small businesses to understand the potential pitfalls of a Chapter 7 bankruptcy as well. The way a Chapter 7 bankruptcy will play out depends upon whether the business is a sole proprietorship, partnership, or a corporate entity.  

(For an introduction to all the bankruptcy options available to small business owners, see Bankruptcy for Small Business Owners: An Overview.)

When a Sole Proprietor Files Chapter 7 Bankruptcy

In a nutshell, if you are the sole proprietor of your business, you are responsible for its debts. This means that if you file bankruptcy, all of your assets and debts – both business and personal – are included in the filing. You can wipe out your dischargeable debts (some debts cannot be discharged in bankruptcy, those are called nondischargeable debts). In return the trustee can sell any of your property that is not exempt by state or federal law, and distribute the proceeds to your creditors. (Learn more about how bankruptcy exemptions work to protect your property.)

This is great if you have a lot of debt and few assets because you’ll likely be able to keep your property while wiping your slate clean of debt.

Conversely, if you own a lot of property, you may have a problem. For example, say you have $200,000 in total debt that you’d like to discharge. Let’s also say you have the following in assets:

  • $300,000 in home equity
  • a car worth $40,000 that you own outright
  • a one-third interest in an LLC in Georgia that holds $500,000 in property
  • a vacation property in Mexico worth $150,000, and
  • two rare hairless cats worth $75,000.

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 a sufficient amount of your property (at fire sale prices) to cover your $200,000 debt load, plus take a hefty, additional amount to pay for the trouble of doing so.

When a Partnership Files Chapter 7 Bankruptcy

Chapter 7 bankruptcy is not as popular for partnerships (and S Corporations, which are similar to partnerships in some ways). This is because the bankruptcy does not discharge the business debt, which means the general partners remain liable to repay it. On top of that, the bankruptcy trustee can pursue the partners personally -– meaning go after their personal assets, such as bank accounts and home equity.

Another option is for the partner to file a personal bankruptcy. Not only does this block financial responsibility stemming from the business, but it also allows the partner to get out from under personal guarantees signed on behalf of the business. However, this option won't work if a partner will lose too many valuable assets by filing for Chapter 7 bankruptcy or has too much income to qualify for Chapter 7 bankruptcy.  

When a Corporation Files Chapter 7 Bankruptcy

Filing Chapter 7 is a great way for a corporation to wind down a business because the bankruptcy trustee is in charge of liquidating the business assets, such as accounts receivables, real estate, and inventory. Once sold, the trustee distributes the funds to the creditors in the manner required by law. This transparency assures most creditors that they are being treated fairly -- which is a good thing.

Opening the Door to Potential Lawsuits

The downside is that filing 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). Filing bankruptcy gives a disgruntled creditor an easy forum to voice its dissatisfaction. Think of it this way – getting a lawsuit started takes a lot of time and energy; however, if the case is already in court, as it is once a bankruptcy is filed, it doesn’t take much effort for the creditor to file an alter ego lawsuit.

Other Reasons Why Chapter 7 Might Not Be Good for Your Small Business

While bankruptcy can be useful for many businesses, it's not always a good idea in every situation. 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.

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 have any effect on 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.

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.

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