How Does a Sole Proprietorship File for Bankruptcy?

A sole proprietorship is a one-owner business (or in some cases, a business owned by a married couple) that has not been incorporated or structured as a limited liability company (LLC). If you have started your own business but haven't created a formal corporate or LLC structure, you have a sole proprietorship. From a legal perspective, there is no separation between a sole proprietorship and its owner: If you owe debts to business creditors, they can sue you personally and take your personal assets (such as your home, car, or money in your personal checking account) to satisfy the judgment.

Because your business is not a separate entity, it can't file its own bankruptcy, as a corporation could. Instead, you must file for personal bankruptcy to rid yourself of business debt. There is a major advantage if most of your debts come from your business, however: You will be eligible to use Chapter 7 bankruptcy without having to pass the means test.

Bankruptcy Options

If you need to file for bankruptcy to get out from under mounting business debts, you will have to file for personal bankruptcy under Chapter 7 or Chapter 13.

Chapter 7

In Chapter 7 bankruptcy, you will have to give up any property you own that isn't exempt under state law (or under federal law, if your state allows bankruptcy filers to choose between the state exemption list or the federal exemption list). Exemptions are intended to let you keep basic necessities. Most states allow debtors to exempt some equity in their home, a car, furniture, clothing, and tools of the trade, for example. (For more information on exemptions, along with links to each state's exemption rules and lists, see Bankruptcy Exemptions - What Do I Keep When I File for Bankruptcy?) Most business property is not exempt, which means you stand to lose it if you file for bankruptcy under Chapter 7.

You do not have to directly repay any debts in Chapter 7. Once you file your paperwork and the trustee decides how to handle your nonexempt property, you will receive your bankruptcy discharge, typically four to six months after you file the case. Many typical business debts, such as debts to vendors or suppliers and credit card debts, will be wiped out.

Chapter 13

In Chapter 13 bankruptcy, you do not have to give up any property. Instead, you must agree to a three- to five-year repayment plan to pay off some or all of your debt. Once you have completed your repayment plan, any remaining dischargeable debts will be wiped out.

Which Option Is Right for You?

Your situation and future plans will dictate whether Chapter 7 or Chapter 13 is the better choice. If you file for Chapter 7, you will get your discharge more quickly, without committing yourself to a repayment plan. However, it's likely that the trustee will take your nonexempt property, sell it, and distribute the proceeds to your creditors. In Chapter 7, the trustee may also decide to shut down your business, at least for the duration of your bankruptcy case, to stop you from running up additional debt or paying off creditors while the trustee is sorting out your affairs.

If you file for Chapter 13, you will have to commit all of your disposable income for at least a few years to repaying your debt. This can make it hard to run a business. And, although your business won't actually be shut down during your bankruptcy case, you will have to get the trustee's permission for even basic financial transactions, which will create significant obstacles to your business endeavors.

The good news is that at least you will have a choice, even if you have a high income. Usually, debtors who want to use Chapter 7 have to pass a means test. If your income is higher than the median income in your state, you must show that you wouldn't have enough money left over, after paying certain allowed expenses, to pay off some of your debt. If the court decides your income is sufficient to pay a minimum amount set by law to your creditors, it can force you out of Chapter 7.

The rules are different if most of your debts come from your business, however. To encourage entrepreneurship, Congress created an exception for business debtors. If more than half of your total debt burden is business-related, you may use Chapter 7 regardless of your income. In other words, you don't have to take the means test.