Small business owners face a complicated question regarding their business debts when they struggle to generate enough cash to pay their monthly obligations. Should they simply try and hope for the best? Or should they file for bankruptcy? If you have debts you can’t pay and you’re thinking about filing business bankruptcy, you’re not alone. There is no absolute right or wrong in answering that question, because it depends upon your situation. However, it is safe to say that filing bankruptcy for your small business is a choice that should never be taken lightly. Before you decide, it helps to understand what business bankruptcy is, how the process works and which type fits your business, without getting lost in the legal lingo.
In simple terms, business bankruptcy is a legal way for a company to get a fresh start. When a business can’t pay its bills, bankruptcy lets it either wind down its operations in an orderly way or, in some cases, reorganize its debts so it can keep running. Either way, creditors receive a portion of what they are owed out of the assets the debtor has available. Bankruptcy is not exclusive to businesses. Individuals can use bankruptcy to escape their personal debt. In 2020 there were 22,482 business bankruptcies and 659,881 non-business bankruptcies, 682,363 in all. Bankruptcy can potentially wipe out every debt you list when you file, but not every debt qualifies. Tax claims, for example, are often excluded.
Why file at all? There are really two reasons. The first is to close the company quickly and relatively easily. Instead of trying to sell off inventory, liquidate equipment or collect outstanding accounts receivable, a business that declares bankruptcy can close its doors without the hassle. The second reason for filing bankruptcy is to keep the business open and continue operating while trying to make the company profitable again. In these cases, the owner is hopeful they will eventually be able to pay their debts. The company owner’s goals and the company’s current financial condition will determine which option is the best.
These aren’t decisions a small business owner ever intends to make. However, poor market conditions, lack of financing, hasty decision-making, cash flow problems and lawsuits can all lead to the need to file for business bankruptcy. It never seems to happen out of the blue; usually, the signs have been there all along.
The Bankruptcy Process
In the United States, bankruptcy is a federal proceeding that is handled by the US bankruptcy courts. To get the ball rolling, you start by filing a petition with the local US bankruptcy court. This petition spells out your name and address, the amount you owe, how many creditors you have and what your assets are worth. Once you file for bankruptcy, an automatic stay goes into effect, which stops your creditors from collecting on your debts. Think of it as a pause button that gives you breathing room to sort things out. During the bankruptcy process, you’ll need to provide full financial information to the court, including all debts, assets, income, and expenses. These bankruptcy schedules also list your contracts and leases. What happens after that depends on the type of bankruptcy you file and how your business is structured.
Chapter 7, Chapter 11, and Chapter 13
For small businesses, the options are Chapter 7, Chapter 11, and Chapter 13. Chapter 7 is called a liquidation bankruptcy. Chapters 11 and 13 are reorganizations. In a liquidation, all assets are sold or otherwise disposed of, all of the proceeds go to creditors and the business is closed. In a reorganization, the business continues to operate, and a portion of the debt is repaid. Which one makes sense depends on whether you want to liquidate or reorganize, and on what kind of entity you have.
Start with Chapter 7. This is the straight liquidation. It’s usually a situation where the business has shut down or is on its way to shutdown. You close the business and give up assets. Sole proprietorships, partnerships, corporations and LLCs can all file, but sole proprietors get a different result than everyone else.
For a sole proprietor, Chapter 7 is cheaper and easier. It wipes out unsecured debts like credit card debt, loans, back rent, utility bills and lawsuit judgments. You don’t have to pay those. It’s the closest thing to a do-over. Now for the not-so-good news. Legally, a sole proprietorship isn’t a separate legal entity, so you are personally responsible, and you could lose your nonexempt personal property, in addition to business property. Some assets are exempt, but things like your equipment, vehicles and mortgage could be seized and sold to pay debts.
Partnerships, LLCs and corporations can file Chapter 7 too, but under Chapter 7 in an entity business the business does not get a discharge. That means the entity goes bankrupt, its property is sold off to pay off creditors as much as possible, but the rest of the debt is still there. That doesn’t make filing Chapter 7 for the entity attractive. It also works if you want to liquidate the company but don’t want to deal with selling off the assets and paying the creditors. They can become a bankruptcy trustee’s problem.
One reason why someone might choose to file a business under Chapter 11 instead of Chapter 7 is if the owner wants to avoid liquidation, or the selling of assets to pay off debts. The company can reduce or renegotiate its debt and continue to operate, all under the watchful eye of a bankruptcy court. The process reorganizes your debts so you can pay them over time in smaller amounts. The catch is that those reorganization payments need to be affordable and supported by your business plan. You need enough cash coming in every month to make them.
Chapter 13 is the other reorganization option, and it comes with a restriction. It is only available to individuals, meaning it is not available to partnerships, LLCs or corporations. Sole proprietors qualify. There’s no simple Chapter 13 for corporations, so if you want a payment plan, you have to file for Chapter 11. Chapter 13 works much like Chapter 11. You keep the business running and keep your business assets. It only wipes out your personal liability for business debts, not the business debt itself.
Should You File
So, should you file? Business bankruptcy isn’t a first step, but when used at the right time, it can be a responsible solution for overwhelmed small business owners. A failing business has several alternatives.
- Can the business organize the balance sheet and work out the cash flow?
- Is there a way to get a big infusion of money?
- Would selling the company make more sense?
Only if you have tried and failed in those areas should you consider bankruptcy. If you get there, choosing the right chapter could keep you from losing everything you have worked for.
