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 business owners options to stay afloat or to expeditiously close a business. What relief bankruptcy can provide to a small business depends on the business and the type of bankruptcy filed. Under Chapter 13 bankruptcy and Chapter 11 bankruptcy, a small business can stay open and make smaller monthly payments to creditors. If a business doesn’t have enough cash flow to make reasonable payments, it can use Chapter 7 bankruptcy to close in an efficient and transparent manner.

Not all bankruptcy options are a good choice for every business, however, because filing bankruptcy affects different business entities in different ways. Choosing incorrectly may negatively affect your personal finances or subject you to litigation. Read on to learn the basics about bankruptcy options for small businesses.

Bankruptcy Options for Sole Proprietors

If you are the sole proprietor of your business, the business is not a separate entity. This means that you and the business are essentially the same and that you are responsible for its debts. Because of this, any bankruptcy you file must include both your personal and business debts and assets.  

Chapter 7 Bankruptcy for Sole Proprietors

The biggest benefit of filing a Chapter 7 as a sole proprietor is that your qualifying business and personal debts will be discharged (wiped out) without you having to make payments over time. this usually happens within a matter of months. (Keep in mind that bankruptcy does not eliminate all types of debts. Learn more about which debts you can discharge in bankruptcy.)

On the flip side, all of your assets -- both business and personal -- become part of the bankruptcy estate. Bankruptcy law allows you to keep certain assets in a Chapter 7 (called exempt assets). If an asset is not exempt, the bankruptcy trustee will sell it and  distribute the proceeds to your creditors.  If you do not have much property, then you'll be able to keep most or all of it, and Chapter 7 could be a good option for you. If, however, you have a sizable estate, you may lose important assets.  (Learn more about using bankruptcy exemptions to protect property.) If that's the case, Chapter 7 may not be your best option.  

Chapter 13 or 11 Bankruptcy for Sole Proprietors

One reason to consider a Chapter 13 bankruptcy (or Chapter 11 if your debts are greater than allowed under Chapter 13) is that it allows the business to continue operating. However, the business must have enough cash coming in each month to make monthly payments, although those payments will be smaller than your current payments. This is often a good choice in the following scenarios:

  • You want to keep the business open (and it generates enough funds to both operate the business and make a smaller monthly payment to creditors).
  • You don’t qualify for Chapter 7 but need protection from creditors.
  • You want to keep more property than is allowed under Chapter 7.

Bankruptcy Options for Partnerships and Corporations

Partnerships and corporations often file business bankruptcies. Unlike sole proprietorships, however, these businesses are not entitled to a discharge of the businesses' debts. There are also no exemptions to protect business property. Below is an overview of the pros and cons of these bankruptcy options.

Pros of Chapter 7 for Partnerships and Corporations

Its often easier to wind down a failing business using Chapter 7 bankruptcy than it is to do so outside of bankruptcy. This is because in Chapter 7 you do not have the burden of selling product, fixtures, or equipment or attempting to collect accounts receivable. The bankruptcy trustee becomes responsible for liquidating the business assets and fairly dispersing the proceeds to your creditors. Not only does this streamline the closure, but also the transparency of the bankruptcy often dissuades potentially disgruntled creditors from claiming fraud – which in turn may save the business money by avoiding litigation.

Cons of Chapter 7 for Partnerships and Corporations

Like sole proprietors, partners are personally responsible for business debt. However, since bankruptcy does not discharge partnership debt, it is important for partners to understand that filing a business Chapter 7 will not get rid of their personal responsibility to pay the business’s bills.

Similarly, while the corporate structure protects shareholders from individual liability, shareholders should be aware that bankruptcy is not without risk. This is because once the corporation files bankruptcy in federal court it is fairly easy for creditors to initiate alter ego litigation -- a lawsuit that asks a court to make the shareholders pay the corporation’s debt -- since the case is already there.

Pros and Cons of Chapter 11 for Partnerships and Corporations

Even though Chapter 13 is only available to individuals and sole proprietors, a partnership or corporation can get similar benefits in Chapter 11 bankruptcy. Chapter 11 allows the corporation to operate while paying less money each month towards its debts. Unfortunately, many small businesses find Chapter 11 cost prohibitive because of the additional rights afforded to creditors and the increased legal fees that result.

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