Bankruptcy laws apply differently depending on whether a business is a sole proprietorship or a partnership. Sole proprietorships must file personally as there is no legal separation between the owner and the business. Therefore, an owner may file for Chapter 7, Chapter 11, or Chapter 13. A partnership can file for Chapters 7 and 11.
Unlike a limited liability company, a sole proprietorship is not a separate entity from its owner. In the case of a bankruptcy, the sole proprietor is personally liable for any business debt or liability. Therefore, creditors can go after the proprietor's personal assets, including any homes, cars, personal bank accounts, and other assets that can go toward unpaid debts. Even if the owner has personal liability insurance, the insurance cannot protect the owner against the creditors' claims. A sole proprietor has three bankruptcy options as detailed below:
- Chapter 7 - Chapter 7 is the "liquidation" bankruptcy and is usually done when continuing the business is no longer financially feasible due to overwhelming debts or a lack of substantial assets. If a business is particularly small or relies solely on the owner's particular skills, it does not make business sense to reorganize. In a Chapter 7 bankruptcy, the bankruptcy court appoints a paid trustee to take possession of the business' assets and distribute them among the creditors. Once the assets are distributed, the sole proprietor receives a "discharge" which releases the owner from and other debt obligations.
- Chapter 11 - Filing Chapter 11 as a sole proprietor, will allow the business to re-organize and continue. As with Chapter 7, the bankruptcy court appoints a trustee. In this case, the owner can also serve as a trustee. The owner must file a reorganization plan that outlines how the business will deal with its creditors. Both the court and the creditors look at the plan. The creditors can vote on the plan and the court will determine if the plan is fair and equitable. If the court approves the plan (which may take a year), the creditors will be paid over a designated period of time not to exceed 20 years.
- Chapter 13 - Chapter 13 bankruptcy is the reorganization bankruptcy usually filed by consumers but can be used for sole proprietorships. Under Chapter 13, a repayment plan is filed with the bankruptcy court that details how the debtor plans to repay the debts. The repayment amount depends on the owner's income, property value as well as the overall debt. If the owner's personal assets are commingled with the business assets, the owner may be able to retain certain assets such as a family home. This protection is not available to a sole proprietor under Chapter 7.
Below are bankruptcy options for partnerships.
- Chapter 7 - As with a sole proprietorship, a bankruptcy court appoints a trustee to oversee the partnership's debts. However, in this case, a partnership does not receive a discharge. Liability remains for all parties involved. The assets are liquidated and paid to the creditors.
- Chapter 11 - A partnership that wishes to continue will file for Chapter 11 debtor. In this case also, a reorganization plan is submitted and creditors are paid over time.
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In a bankruptcy sole proprietorship is treated differently than a partnership with regards to discharge of debts. Discuss your case with a bankruptcy attorney to ensure that your rights are protected throughout the bankruptcy.