How Does a Sole Proprietorship File for Bankruptcy?

Filing for bankruptcy can be a very effective way for a sole proprietorship to eliminate debt and, in many cases, remain open. Learn why sole proprietorships have more bankruptcy options and often pay less to file than other business types like partnerships, limited liability companies ("LLCs"), and corporations.

What Is a Sole Proprietorship?

A sole proprietorship is your business type if you haven't taken any steps to create a separate business entity. For instance, if you didn't form a corporation or limited liability company ("LLC"), you're a sole proprietor.

Example. During summer, Jonathon and his friends regularly dance West Coast Swing at a local concert in the park event. When other attendees asked for lessons, he started charging $5 per person to teach the basic steps. Because he did nothing to formalize his new side business, Jonathon is a sole proprietor.

How Do Sole Proprietorships Differ From Other Business Types?

Unlike corporations and LLCs, a sole proprietorship isn't a legal entity separate from its owner. Because the business and owner are considered the same, no distinction exists between business and personal assets or debts.

As a result, the way a sole proprietorship owns property and pays debt differs significantly from that of other business types. The sole proprietor owns the business property outright, along with the owner's individual property. Also, a sole proprietor owner doesn't receive protection from business creditors.

What's the result? A business or personal creditor who sues and wins a money judgment can take business or personal assets to satisfy it.

Example. Lola sued Tiny Hand Pies and won a money judgment for $15,000 after the company failed to pay for multiple blackberry shipments. To collect, Lola asked law enforcement to take money directly out of Tiny Hand Pie's cash register using a "till tap," a collection technique regularly used to collect from businesses. When the officer recovered only $700, Lola used a "bank levy" to withdraw the remaining $14,300 from owner Trina's personal bank account. Lola could do this because Trina operated Tiny Hand Pies as a sole proprietor, exposing both Trina's individual assets and Tiny Hand Pie's assets.

Learn more about creditor lawsuits and judgments.

Bankruptcy Options for Sole Proprietors

Because a business operating as a sole proprietorship isn't separate from the owner, owners file for bankruptcy in their names using the bankruptcy forms intended for individuals. Sole proprietor owners don't file using business names and non-individual forms. Instead, the individual petition forms have a place to list any sole proprietorships operated.

Filing as an individual gives a sole proprietor more bankruptcy options than other business types. Specifically, Chapters 7 and 13 are available to sole proprietors, with Chapter 7 offering more substantial benefits than those available to other businesses. Companies that aren't sole proprietors don't qualify for Chapter 13 whatsoever.

We explain both chapters below.

Chapter 7 Bankruptcy for Sole Proprietors

A Chapter 7 case filed by a sole proprietor will proceed much like any other Chapter 7 case filed by an individual. The matter will include the filer's individual and business debts and property—the filer can't separate or exclude either.

However, a sole proprietor will find more value in Chapter 7 than other companies, and sometimes, it's easier for a sole proprietor to qualify for Chapter 7 than other individuals. Here's why.

Sole Proprietors Can Discharge Debt

In Chapter 7, a sole proprietor can eliminate qualifying debt in about four months without repaying creditors. Before filing, you'll want to explore the types of debt erased in Chapter 7 and nondischargeable debts you'll still owe after bankruptcy.

Other business types can't discharge any debts in Chapter 7. All debt remains in place. This approach allows creditors to pursue individuals who put up collateral for the debt or signed personal guarantees—an agreement by an individual to pay a business debt if the business can't pay—after the case closure.

Sole Proprietors Can Keep Property

Sole proprietors in Chapter 7 can protect property needed to work and live using bankruptcy exemptions so you won't lose everything you own. Other business types can't keep assets in Chapter 7. The business relinquishes all property and it's sold for the benefit of creditors, which essentially closes the business.

It's important to understand that the Chapter 7 trustee—the official overseeing the bankruptcy case—can sell the business or its parts to the highest bidder, individually or together. You must protect whatever is saleable with a bankruptcy exemption to keep it. Although the trustee can't sell your labor, the trustee can sell equipment, customer lists, "accounts receivable" or unpaid invoices, and more.

Learn how trustees get paid in bankruptcy.

Sometimes, Sole Proprietors Can Stay Open

A sole proprietor who doesn't need property to remain in business—or who can protect needed property with bankruptcy exemptions—can often stay open after Chapter 7. Many owners in this position find their businesses revitalized after discharging significant debt.

However, some bankruptcy trustees will close the business temporarily. You should anticipate providing proof of liability insurance if you hope to continue operating during Chapter 7. Find out whether you'll have to close your business in Chapter 7.

Some Sole Proprietors Qualify Automatically

Chapter 7 is intended for filers who can't repay creditors, and most filers must pass the Chapter 7 means test, which screens a filer's ability to pay. However, suppose more of your debts are "business" debts from business activities rather than "consumer" debts for living expenses. In that case, you'll be exempt from taking the Chapter 7 means test.

People who have moved on from a failing sole proprietorship and have secured high paying jobs often benefit from this exception. However, you should be aware that you'll also disclose your monthly income and expenses elsewhere in your bankruptcy petition. If it shows you have disposable income to pay creditors, the trustee will recommend that the bankruptcy court convert your case to Chapter 13, even if you're exempt from taking the means test.

Learn what's involved in the Chapter 7 bankruptcy process.

Chapter 13 Bankruptcy for Sole Proprietors

A significant bankruptcy benefit available to income-generating sole proprietors is the ability to file for Chapter 13 bankruptcy. The Chapter 13 process is more streamlined than the restructuring options available to other business types.

Sole Proprietors Restructure Business and Personal Debt

Income-generating sole proprietors struggling to pay monthly bills can use Chapter 13 to lighten their business and personal debt load in one case. For instance, a sole proprietor could save a home from foreclosure, reduce the amount paid to business creditors, and pay less on medical bills, personal credit lines, utilities, and overdue cellphone bills, all in the same action.

Chapter 13 filers pay creditors their "disposable income" for three to five years. After completing the repayment plan, the bankruptcy court discharges the remaining balances on qualifying debt.

Chapter 13 isn't available to other business types. They're limited to Chapter 11 bankruptcy for debt restructuring, which is far more complicated and expensive—although Chapter 11 Subchapter V offers small businesses a cheaper, more streamlined option. Learn about the differences between Chapters 11 and 13.

Sole Proprietors Keep Property

One benefit of Chapter 13 is that, unlike in Chapter 7, the trustee doesn't sell nonexempt property. However, you must pay to keep it by paying creditors an amount equal to the nonexempt portion. Because most states don't protect much business property, this criteria can make Chapter 13 too expensive for businesses with costly equipment, inventory, and other valuable assets.

Learn how to calculate a Chapter 13 plan.

Is Chapter 7 or 13 Better for Sole Proprietors?

Chapters 7 and 13 offer different benefits and have different qualification requirements. What you'd like to achieve and your ability to qualify for a particular chapter will determine whether Chapter 7 or Chapter 13 is right for you.

Pros and Cons of Bankruptcy Chapter 7 for Sole Proprietors

The benefits of Chapter 7 include getting a discharge quickly without repaying creditors. However, Chapter 7 doesn't discharge all debt types and won't help you stop foreclosure or a vehicle repossession.

Also, the trustee will sell property you can't protect with a bankruptcy exemption and distribute the proceeds to your creditors, which could deprive you of property you don't want to lose or shut down your business. The trustee might also decide to close your business during your bankruptcy case to avoid liability while the trustee is sorting out your affairs.

Pros and Cons of Bankruptcy Chapter 13 for Sole Proprietors

In Chapter 13, you can restructure business and personal debt, usually paying less on both. For many business owners, reducing debt is enough to keep a business afloat.

However, paying into a Chapter 13 plan can make it hard to run a business because you must commit all disposable income to debt repayment for three to five years, which is a long time. It can be challenging if expensive issues pop up regularly that need the trustee's permission to proceed.

Consult a Business Bankruptcy Lawyer

You can expect a bankruptcy lawyer to address many of the issues discussed in this article and more (it's impossible to cover all potentialities in a single article). The lawyer might even suggest a nonbankruptcy option that is better suited to your situation. Bankruptcy attorneys who regularly represent businesses know companies' challenges and the options available to resolve those problems.

Most people considering filing for bankruptcy find that meeting with a bankruptcy lawyer is well worth the consultation cost, and many lawyers don't charge for the initial meeting. Learn how bankruptcy lawyers get paid.

Navigating Your Bankruptcy Case

Bankruptcy is essentially a qualification process. The laws provide instructions for completing a 50- to 60-page bankruptcy petition, and because the rules apply to every case, you can't skip a step. We want to help.

Below is the bankruptcy form for this topic and other resources we think you'll enjoy. For more easy-to-understand articles, go to TheBankruptcySite.

We wholeheartedly encourage research and learning, but online articles can't address all bankruptcy issues or the facts of your case. The best way to protect your assets in bankruptcy is by hiring a local bankruptcy lawyer.