Is Bankruptcy a Good Option for Struggling Small Businesses

Each bankruptcy chapter offers unique benefits that will differ depending on whether you or your company file for bankruptcy. It's essential to know how bankruptcy works, including when bankruptcy protects property and erases debt (it doesn't always do so). This article also explains why Chapter 7 closes most small businesses, how Chapter 11 or 12 can help a small business remain open, and when a business owner should file for bankruptcy rather than the company itself.

How Bankruptcy Works

A failing business that isn't generating enough income to reorganize through another chapter can use Chapter 7 to close or unwind it. Individuals with minimal property and insufficient income to repay debt also use Chapter 7.

It's known as a "liquidation bankruptcy" because the Chapter 7 bankruptcy trustee appointed to oversee the case sells the filer's assets and distributes the proceeds to creditors. While the trustee will sell all of a company's assets, individuals filing for Chapter 7 don't lose everything—they can keep any assets protected by state exemption statutes.

Chapters 11, 12, and 13 are "reorganization bankruptcies" for higher income-earning individuals and ongoing businesses that would like to remain open. In a reorganization bankruptcy, the filer agrees to pay into a repayment plan and, in most cases, will pay less than owed or get better terms. In these bankruptcies, the trustee doesn't sell property, so a filer can keep all assets if they can afford to do so.

Tip. A bankruptcy attorney can explain how to use bankruptcy chapters in creative ways. For instance, a filer can use Chapter 11 as a liquidation bankruptcy when it would be beneficial to involve creditors in selling business assets. And a service-oriented sole proprietor without much in the way of property can often benefit significantly by filing for Chapter 7. It reduces personal and business debt while allowing the filer to continue providing a service (more below).

What Is Small Business Bankruptcy?

The term "small business bankruptcy" can confuse people because both the small business itself and a business owner or stakeholder can file for bankruptcy. While bankruptcy professionals might call both types "business bankruptcies"—see the explanation in the "Tip" below—in this article, the business itself is filing the small business bankruptcy, not the owner or stakeholder. By contrast, a small business owner would file a personal, individual, or consumer bankruptcy in the owner's name.

Which Bankruptcy Chapters Can a Business File?

Chapters 7, 11, and 12 are available to businesses. A company can't file for Chapter 13, although it is available to sole proprietors. Keep reading to learn about the pros and cons of each chapter type.

How Can Chapter 7 Bankruptcy Help Your Small Business?

Chapter 7 can help a business owner wind down the business transparently. It helps assure creditors that all business assets will be liquidated and the funds distributed as outlined in bankruptcy law. It's relatively inexpensive and can save an owner time and energy if the business owns significant property.

Tip for sole proprietors. Sometimes, Chapter 7 can help a sole proprietor in a service-oriented business, such as accountants and coaches, remain open and be more profitable. A sole proprietor can wipe out personal and business debt in Chapter 7. People who provide services rarely need to worry about losing the property necessary to run the business. Plus, most states allow a filer to protect some professional tools. However, the key that allows this to work is that a trustee can't sell an individual's labor. The sole proprietor will be free to continue providing the service after the bankruptcy case ends and possibly during the bankruptcy itself (more below).

Downsides to a Small Business Chapter 7 Bankruptcy

Chapter 7 doesn't provide the business with a debt discharge—any outstanding debt balances will remain payable by the company, and owners remain liable for the business debt. Liability can result from the type of business organization, such as a partnership. It can also be due to signing a personal guarantee or because of the debt type, such as employment taxes.

The Chapter 7 trustee will likely sell the property quickly and probably for less than the owner would sell it, leaving a liable owner to pay a more substantial portion of the business's debt.

Also, many small business people don't find that filing for Chapter 7 bankruptcy offers enough value to offset the scrutiny involved, which could increase personal liability. Notably, filing raises the chances that a creditor will allege misdealings such as fraud, thereby opening the door to personal responsibility, mainly because even if the case is meritless, defending it will be expensive. A partnership virtually never files for bankruptcy because if the assets aren't sufficient to pay the debt, the trustee might look to the partners for payment.

When Should a Small Business File for Bankruptcy Chapters 11 or 12?

A Chapter 11 case helps when an operating business generates income but not enough to cover expenses. The debtor and creditors agree to new payment terms in a plan of reorganization. Historically, Chapter 11 bankruptcy has been too expensive for a small business to use. Now, another option exists. Chapter 11, Subchapter V offers a cheaper, more streamlined way for a small company to reorganize debt and stay in business. Chapter 12 provides a more straightforward reorganization strategy for farmers and fishermen than what is ordinarily available under Chapter 11.

Both Chapter 11, Subchapter V, and Chapter 12 cases have debt limitations. Also, any bankruptcy chapter can open up liability issues if a creditor suspects fraud or that the owner hasn't been forthright in handling the business assets.

Personal Bankruptcy for Small Business Owners

A small business owner who files individually (in the person's, not the business's name) can use bankruptcy to minimize personal expenses, thereby leaving more income for the company. Filing for bankruptcy can also wipe out the individual's liability to pay for business debt after a business closure. However, depending on your business and the bankruptcy trustee, you might need to close your business while you're in bankruptcy (but not always).

Which Bankruptcy Chapters Can a Small Business Owner File Personally?

Individuals can file for Chapter 7 or Chapter 13 (or Chapter 11 when the filer's debt balances exceed the Chapter 13 limits).

Chapter 7 filers must pass the Chapter 7 means test unless they have more business debt than personal debt—in that case, they'll be exempt. Chapter 13 filers' debt cannot exceed current balance limitations, and filers must have enough income to pay the debts required under the chapter. Chapter 11, Subchapter V small business filers can't exceed debt limitations and must submit a reasonable plan.

Is One Bankruptcy Chapter Better Than Another?

It will depend on whether the individual wants to keep the business open, whether the person qualifies for the particular chapter, and whether a specific problem stands in the way of the filing. For instance, the more valuable the company, the more difficult it can be to preserve it in an individual filing. A bankruptcy lawyer can predict a debtor's chances of keeping an existing business.

Downsides to a Small Business Owner Filing for Chapter 7 Bankruptcy

In most cases, Chapter 7 will shut down a company or cause a business owner to lose it. Here's why. A sole proprietor will include the value of the business and business assets in the case. As with all property, the trustee will sell nonexempt assets. So, a filer will lose any property not protected by a bankruptcy exemption. Similarly, any other ownership interests must be disclosed, such as the value of shares or membership percentage, and the trustee could sell these, too.

A local attorney can tell you how to keep your business open during the case. For instance, some trustees will allow it after providing proof of liability insurance. Your lawyer would likely contact the trustee early to work through any issues.

Can a Small Business Owner Benefit From Filing a Personal Chapter 13 Bankruptcy Case?

A business can't file for Chapter 13. Still, a business owner can—either while operating a company or after it has closed. In most cases, Chapter 13 will reduce the amount the filer must pay toward the filer's debt obligation, primarily unsecured debts, such as credit card balances, medical bills, and personal loans—often substantially. And that reduced monthly payment can be just the relief the filer needs.

A filer can also keep all property in Chapter 13—the trustee won't sell it. But this isn't a freebie. The value of nonexempt property must be paid for through the monthly repayment plan. So proposing a successful repayment plan might not be possible if valuable ownership interests exist (more below.)

Chapter 13 also provides mechanisms to reduce secured debt balances in some instances. For example, you can strip off a wholly unsecured junior home mortgage. For instance, if your home equity of $100,000 wasn't enough to fully pay your $130,000 first and second mortgages, you could strip off your wholly unsecured third mortgage.

Another benefit of Chapter 13 is that you can cram down the amount owed on business property, vacation rental, or vehicle. This process works well if you owe more than what the property is worth because the new crammed down amount reflects the actual value of the property.

Finally, more debt can be discharged in Chapter 13 than in Chapter 7. For instance, tax payments made by credit card and marital property division debts can be wiped out only in Chapter 13. Learn about choosing between Chapter 7 and Chapter 13.

Downsides to Filing a Personal Chapter 13 Bankruptcy Case

The filer's debt can't exceed current debt limits (a filer whose debt exceeds the Chapter 13 threshold can file an individual Chapter 11 case). The debtor must pay all disposable income into a three- to five-year repayment plan, so getting through the process can be difficult, especially since Chapter 13 plan payments can be pretty high.

A filer who wants to keep collateral—like a house or car— must repay all mortgage, vehicle, and other secured debt arrearages in the plan. Other priority debts, such as current tax balances and domestic support arrearages, must be paid in full through the plan. And cramming down the balance of secured debts can be advantageous, but the crammed down amount must be paid in full in the plan, a prospect that can get expensive quickly if you'd like to cram down business, rental, or vacation real estate.

Finally, the filer will have to pay the value of any property to keep any property that isn't protected by a bankruptcy exemption. In many cases, a debtor with a significant amount of nonexempt assets won't earn enough to make the required plan payment. For example, a filer with $300,000 in nonexempt assets—say, equity in a commercial rental—would have to pay a minimum of $5,000 per month to keep the property. These required payments often derail a potential Chapter 13 filing.

What is an Individual Chapter 11 Filing?

Filers with debt exceeding the Chapter 13 limits can file an individual Chapter 11 case. If the debtor fits within Chapter 11, Subchapter V requirements—the more straightforward Chapter 11 filing for small businesses and individuals—it will proceed much like a Chapter 13. Learn about choosing between Chapter 13 and Chapter 11.

Consult With a Bankruptcy Lawyer

Each bankruptcy case is unique, and a bankruptcy lawyer is in the best position to review your matter and explain how to meet your goals. Because of the complicated nature of bankruptcies involving small businesses, hiring an attorney is strongly recommended and mandatory if the company itself files the case.