Running a business is hard enough without a crisis halting the wheels of production. When the crisis continues, costs pile up and problems quickly spin out of control. The pandemic proved it: more than a third of the country’s 32.5 million small businesses closed at some point, temporarily or for good, and the forgivable federal loans weren’t enough to prevent widespread closures. Since companies with fewer than 100 employees make up 98.2% of all U.S. businesses, that’s a big problem. Debt is a key reason why many small businesses shut down for good. Many more are left nearly bankrupt. Some owners simply lock the doors. Others file for bankruptcy.
Which kind of bankruptcy depends on four questions.
- How is your business structured?
- Who is liable for the debt?
- Do you want to stay in business?
- And do you have a viable plan for doing that?
The answers to those questions will help you identify the right sort of bankruptcy. As with most problems in business and finance, one solution does not fit all, and the bankruptcy code offers enough choices that most owners can find a fit. There is also a newer law, the Small Business Reorganization Act, that may be just the lifeline some companies need.
Sole Proprietorship
Start with the sole proprietorship. As a sole proprietor, you are personally liable for the debts of your business. If your business is a sole proprietorship without a separate legal entity, like a corporation or an LLC, the bankruptcy code sees the business and its owner as the same entity. That means creditors can pursue the owner personally for business debts and put the owner’s property at risk. Both spouses can be liable in the case of a married couple. That makes choosing the right chapter critical.
Chapter 7 is also known as liquidation, or straight bankruptcy. A Chapter 7 liquidation shuts down the business. A trustee is assigned to your case and takes over any assets that you are not allowed to keep, sells them, and distributes the proceeds among your creditors. Depending on state law, you may keep items like some home equity, vehicles, furniture, clothes and tools of your trade, but exemptions for business assets are usually modest. In practice, filing Chapter 7 will likely mean losing the business. State laws can vary in terms of how broadly they define those necessities and to what extent they allow you to hang on to them. You can’t keep it all.
There are upsides, though. If most of the debt is business-related, the owner can file Chapter 7 without meeting the means test. And one advantage of Chapter 7 is that you can wipe out the underlying debts of the business with no obligation to make any payments. Debts to suppliers, landlords, vendors and credit card companies are discharged. You no longer owe these debts. The process from filing to discharge is relatively short, typically four to six months. After that you start a new life, free from your business debts.
Chapter 13 is the other route for a sole proprietor. A key similarity between Chapter 13 as it applies to a sole proprietor, and a basic Chapter 13 consumer case, is that the debtor will make payments to a Chapter 13 trustee. The trustee will then distribute that money to the creditors. These payments to the trustee will come out of the debtor’s regular earnings. Because the Chapter 13 plan can continue for a period of 3 to 5 years, a business owner needs to show that their business brings in a relatively constant stream of income. The court has to approve the plan. If your Chapter 13 plan is based on the income from your business, the success of your plan will depend on the success of your business. If you are current on the plan, your remaining balance is discharged, and you can continue operating the business without further court supervision, keeping both personal and business assets.
You have to qualify, however. Under the limits that applied when the Small Business Reorganization Act took effect, if your unsecured debts exceed $419,275 or your secured debts exceed $1,257,850, you can’t use Chapter 13. Secured debts are loans backed by assets. Check the figures that apply when you file.
The Debt of the Partnership
Partnerships are formal arrangements between two or more parties to run a business, but technically a partnership is not a separate legal entity. It is just an economic relationship between individuals. As a result, if one partner runs into financial trouble, they can end up dragging the others down with them. In good times partners share the profits; in bankruptcy they may share the obligation to pay the debts, depending on how the partnership is structured.
If your partnership files under Chapter 7, regardless of its structure, expect to lose your investment, to deal with lawsuits outside the bankruptcy court, and (most likely) to see the partnership go out of business. Although a Chapter 13 reorganization may be possible, there are difficulties. If some or all of the partners have sufficient personal assets to pay the partnership’s debts, then creditors are unlikely to agree to a long-term, partial payment of debts, and a creditor may well seek to convert the bankruptcy to a Chapter 7 to collect the entire debt.
That’s why most partnerships include a provision in their agreements that automatically dissolves the partnership if one partner files for bankruptcy, preventing trustees or creditors from suing the other partners for debts. It sounds dramatic, but this clause essentially acts like a pull cord. You pull it, and the entire operation grinds to a halt. Without this provision in place, it can be time consuming to figure out whether the partnership’s assets will cover the debt, or there will be a deficiency. In the meantime, the court may limit the general partners’ transfer of personal assets, or require that they post a bond or otherwise assure they are good for any deficiency.
The type of partnership matters. In a general partnership, the partners are personally liable for the debt of the partnership in a Chapter 7 case. In a limited partnership, you have general partners and limited partners; the limited partners are only liable for any debts they personally guaranteed. So even though both a general partnership and a limited partnership may file for bankruptcy, the risk and liability are very different. In a limited liability partnership, which not all states allow in their legislation, a partner’s liability for partnership debts may be limited, though again they remain personally liable for any debts they guaranteed.
If Your Business Is Structured as an LLC
A limited liability company creates separation between the business and the people who run it. When an LLC files for Chapter 7, the business itself will be wiped out by the bankruptcy. Its assets are liquidated to pay its debts, but a company filing bankruptcy does not automatically drag its owners into the bankruptcy. If your business is structured as an LLC, you generally are not personally liable for business debts unless you personally guaranteed them. If you guaranteed a loan, the creditor will be able to come after you as an individual and collect on the guarantee. Any owners who signed personal guarantees on the debts of an LLC may need to file for personal bankruptcy to get free of that liability.
An LLC that has simply hit a rough patch and sees a viable way forward can also choose Chapter 11 reorganization. With Chapter 11, an LLC can restructure its debt and try to avoid default. If successful, the business can continue operating and move forward. Once upon a time, Chapter 11 bankruptcy was affordable only to corporations with lots of money. The Small Business Reorganization Act, which went into effect in February 2020, makes the process of filing Chapter 11 simpler for small businesses, and the CARES Act increased the debt limit from $2,725,625 to $7,500,000 for cases filed between March 28, 2020 and March 27, 2021. That window has closed, so the ceiling for a filing in 2026 is a question for your lawyer. There are a few options that should be discussed with an attorney.
It may seem like bankruptcy means a lifetime of financial ruin, but when you are simply unable to overcome your financial difficulties, declaring bankruptcy can be a smart decision that will help you get back on your feet. Know your structure, know who is liable, and be honest about whether the business has a future.
