Bankruptcy for Small Business Owners: An Overview

An introduction to the various bankruptcy options for small business owners and the pros and cons of each.

Bankruptcy can offer struggling small business owners options to stay afloat or to close a business expeditiously. But not every business entity can file, or benefit from, each bankruptcy type. The following are a few of the options available:

  • Under Chapter 11 bankruptcy, a small business with sufficient cash flow can stay open and make smaller monthly payments to creditors.
  • A company without cash flow can use Chapter 7 bankruptcy to close efficiently and transparently.
  • In some instances, a sole proprietor can keep a business open by filing a Chapter 13 bankruptcy, or even a Chapter 7 if the company provides services only.

Because a poor choice can negatively affect a debtor's personal finances or subject the debtor to litigation, be sure to consult with a bankruptcy lawyer experienced in filing small business cases.

Bankruptcy Options for Small Businesses Owned by a Sole Proprietor

If you're the sole proprietor of your business, you and the company are essentially the same, and all of your financials—both personal and business—will be part of the bankruptcy filing. You'll provide bank statements, profit and loss statements, tax returns, and other documents for yourself and the business.

Filing for Chapter 7 Bankruptcy as a Sole Proprietor

A sole proprietor typically uses Chapter 7 after a business closure (but not always—more below). The benefit to the filer can be substantial because Chapter 7 will discharge (erase) both qualifying business and personal debts, thereby genuinely giving the debtor a fresh start. Unlike a Chapter 11 or 13 filing, Chapter 7 doesn’t require creditor repayment. And it's fast, taking three to four months to complete.

The downside is that all business and personal property become part of the bankruptcy estate. But you won’t lose everything. Bankruptcy law allows you to keep “exempt” assets in Chapter 7, such as some equity in a home and car, household goods, a retirement account, clothing, and a small amount of the equipment needed in your profession. The Chapter 7 bankruptcy trustee sells assets that aren’t protected by an exemption and distributes the proceeds to creditors.

The downside? A filer with a sizable estate could lose property in Chapter 7—including the actual business if it’s a company with valuable assets and the trustee was able to find a willing buyer. So if you own an attractive ongoing operation that you can’t protect (try a wildcard exemption), you could lose it in Chapter 7.

Important Tip: Keeping a Service-Only Business in Chapter 7

If you’re a handyman, accountant, dance instructor, or freelance writer, your business might be safe in Chapter 7. Why? Because the trustee can’t sell your future services or force you to work for someone else. Also, most states exempt a small amount of equipment needed in a profession, so it’s possible to retain some necessary tools, too. And some trustees will let you continue working during the bankruptcy if you have liability insurance. Speak with a local bankruptcy attorney experienced in business filings to see if this approach will work for you.

Filing for Chapter 13 or Chapter 11, Subchapter V as a Sole Proprietor

If you want to continue operating a company, consider filing for Chapter 13 bankruptcy (or Chapter 11, Subchapter V if your debts exceed the Chapter 13 debt limits). You'll be able to continue operating the business as long as the business has enough cash flow to meet the required Chapter 13 monthly payments, which can be more affordable than the current obligations in many cases.

Because you don’t give up property in Chapter13, it can work well if you need more property to run your business than you could keep under Chapter 7, or if the Chapter 7 trustee would sell your business.

Keep in mind, however, that this benefit comes at a price. You must pay creditors an amount equal to the value of your nonexempt property through the repayment plan. And you must be able to prove that you have sufficient self-employment income to support the bankruptcy case. So if your business requires expensive equipment that you can’t protect with a bankruptcy exemption and the business doesn't earn enough to pay the equipment's value through the plan, a Chapter 13 won’t be feasible.

If your business is closed and you don't qualify for Chapter 7, consider Chapter 13 bankruptcy. You can pay off your debt over three or five years without worrying about creditor collection actions.

Bankruptcy Options for Small Business Partnerships and Corporations

It’s rare for a partnership or corporation to file for Chapter 7 bankruptcy because the potential pitfalls usually outweigh the benefits. Most opt for a Chapter 11 filing, instead. Below is an overview of some of the benefits and potential problems that come with these bankruptcy options.

How Chapter 7 Can Benefit a Small Business Partnership or Corporation

When a business closes, business owners and stakeholders have an obligation to liquidate the company assets and distribute the proceeds to creditors. When a failing business owns a significant amount of property or has a substantial number of creditors, it can be simpler to use Chapter 7 for the wind down instead of doing so outside of bankruptcy. The company relinquishes the responsibility of dealing with the assets to Chapter 7 bankruptcy trustee, leaving the trustee to sell any product, fixtures, and equipment and collect accounts receivable.

Not only does filing for Chapter 7 streamline the closure of the business, but the transparency of selling assets through the bankruptcy proceeding can help dissuade potentially disgruntled creditors from claiming fraud or alleging that the stakeholders raided assets before closure. Avoiding this type of litigation could save all involved substantial legal costs.

Problems a Small Business Partnership or Corporation Might Face in Chapter 7

Partnerships and corporations aren't entitled to debt discharge in Chapter 7—so even after the Chapter 7 case ends and the business closes, the business debts will remain. Usually, this isn’t a problem because a creditor can’t collect debts from a nonexistent company. However, creditors can still collect from individuals personally liable for company debt, such as small business partners.

The critical point is that filing a business Chapter 7 case will not eliminate the partners’ personal and individual responsibility to pay the business's bills. And the Chapter 7 trustee might look to the partners' personal assets for payment, so it’s virtually unheard of for a partnership to file for Chapter 7 bankruptcy.

Similarly, while the corporate structure protects shareholders from individual liability, shareholders should be aware that bankruptcy is not without risk. Once the corporation files for bankruptcy in federal court, the door is open for creditors to initiate alter ego litigation (a lawsuit that asks a court to make the shareholders personally liable for the corporation's debt). It’s not that a bankruptcy filing is necessary for an alter ego filing. The filing of a bankruptcy case can trigger a creditor to take action to protect a claim that the creditor wouldn’t have taken otherwise.

Important Tip: Filing a Personal Chapter 7 After a Business Closure. A more straightforward and often more effective way to wipe out personal liability for a business debt—including a personal guarantee—is to file for Chapter 7 individually after a business closure. Although the filer’s nonexempt personal property could be at risk, if the filer’s business debt exceeds all other debt, the filer won’t need to qualify by passing the Chapter 7 means test. This “loophole” allows the filer to wipe out qualifying debt in Chapter 7 despite making a considerable salary. Consult with a knowledgeable bankruptcy lawyer experienced in business bankruptcies.

Small Business Partnerships and Corporations in Chapter 11, Subchapter V

Because Chapter 13 is only available to individuals and sole proprietors, partnerships and corporations that seek to stay open by restructuring debt must look to Chapter 11. Chapter 11 allows companies to operate while paying less toward debt.

In the past, many small businesses found Chapter 11 cost prohibitive because of the additional rights afforded to creditors and the increased legal fees that result. However, the relaxed procedural requirements of Chapter 11, Subchapter V give small business owners the option of restructuring debt using processes similar to Chapter 13 bankruptcy. Your bankruptcy lawyer can evaluate whether Chapter 11, Subchapter V will work for you.

Consult With a Bankruptcy Lawyer

Business bankruptcies are complicated, and in many instances, a bankruptcy attorney must file the case. Filers should seek legal advice from a knowledgeable bankruptcy attorney early in the process to ensure adequate protection of their interests.

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