There’s no single bankruptcy that wipes out every dollar of debt. The question I hear most is which chapter will wipe out all of my debts. Short answer: none. Some obligations, like certain tax debts, may stick around no matter what. What gets wiped depends on the chapter of bankruptcy you file and your legal structure. Businesses generally have three routes: Chapter 7, 11, and 13. They work differently.
What is bankruptcy? It’s the legal process when you can’t repay your debts. In a bankruptcy, the debts are either eliminated or put on a repayment plan. Creditors then get a certain percentage from the available assets of the bankrupt party (you, or your business). Both individuals and businesses file for bankruptcy. There were 22,482 business bankruptcies and 659,881 non-business bankruptcies filed in 2020.
Most business owners I talk to file for bankruptcy for one of two reasons: to shut the company down fast, without having to sell every item, dispose of equipment, and chase unpaid bills. Or they do it to stay open, while keeping their debt under control. There are a few common reasons that force people into bankruptcy:
- weak market conditions,
- no financing,
- rash decisions,
- cash flow issues,
- or legal trouble.
How does filing work? It’s the Federal Courts that handle bankruptcy, so you file a petition in your local federal bankruptcy court. The petition itself will ask for your name, address, the amount of your debts, the number of your creditors, and the value of your assets. When you file, an automatic stay kicks in, which means creditors have to halt collection efforts. You will also need to file schedules that show what you own and owe and what your income and expenses are, and a list of your contracts and leases.
What happens when you file for bankruptcy depends on what kind of bankruptcy and your structure. Sometimes, the business debts are wiped clean. Sometimes, depending on the chapter and structure, your personal assets could still be on the line. Sole proprietors, partnerships, corporations, and LLCs can all file Chapter 7, but the outcome for a sole proprietor is different.
Liquidation and Reorganization
What’s the difference between liquidation and reorganization? There are two big categories. Chapter 7 is liquidation. Chapters 11 and 13 are reorganization. In liquidation, the business shuts down and the assets are divided among the creditors. In reorganization, you restate assets and liabilities to try and keep the company alive. It involves new arrangements with creditors, and you keep on operating. Which one you choose will depend on if you want to close or not, and the type of business entity you have.
Chapter 7 is what most people think of when they hear “bankruptcy.” It’s straightforward: you liquidate your assets, pay what you can, and most of your unsecured debts go away. Sole proprietors facing Chapter 7 bankruptcy can wipe out unsecured debts like credit card bills, business loans, back rent, utility bills, and judgments from lawsuits. Chapter 7 allows most business and personal debts to be relieved. This bankruptcy chapter is much cheaper and easier than the other ones for a sole proprietor. The catch? In Chapter 7 bankruptcy a sole proprietorship is not a separate legal entity so the owner’s personal assets are at risk. Some assets may be exempt from the trustee’s control, but the business equipment, vehicles, and home mortgage could be seized and sold.
That sounds like a clean break, and sometimes it is. But for many businesses, it’s a little messier than that. I like to tell partners, corporations, and LLCs they can file a Chapter 7 too. But a Chapter 7 is very different for a partnership, corporation or LLC. If you’re considering a Chapter 7 to clean your slate, this can be a real turnoff: Unlike a sole proprietor, the partnership, corporation or LLC will not be able to wipe out its business debts with a Chapter 7 bankruptcy. It must close shop. On the other hand, the bankruptcy trustee, and not the owners, does the work of selling off the assets and paying the creditors.
Keep the Business Operating
It’s worth knowing that Chapter 11 is a reorganization, not a liquidation. You stay in control of your business and continue operating, but you do so under the rules of the bankruptcy case. Individuals and businesses can both file for it. It restructures your debts so you pay the creditors more manageable monthly amounts, with one big requirement: you need to have enough incoming cash each month to keep up the new payments. This is usually for business owners who still have the desire and the means to keep things going.
Chapter 13 is reorganization. Only individuals can file Chapter 13. You, the sole proprietor, can, but a partnership or corporation or LLC cannot. You keep the business operating like you do in Chapter 11, while paying your creditors. You don’t have to surrender your business assets. However, the catch is that it only wipes out your personal liability for business debts, not the business debt itself.
Which Chapter Will Wipe Out the Most Debt?
I know it’s painful, but I’d rather talk about this when your head is cool than have you do something emotional when you’re desperate. Which chapter will wipe out the most debt? If you’re operating as a sole proprietor, Chapter 7 will get rid of most of your unsecured business and personal debts. (Claims of tax authorities may survive, and some of your personal property may be lost if it’s not exempt.) If you’re an LLC or corporation, Chapter 7 won’t wipe out your business debts. It’ll just shut you down. Chapters 11 and 13 do not wipe debt out, but they do restructure it in a way that allows you to keep your business.
If things are getting bad, don’t make bankruptcy your first call. Before you do, try fixing the cash flow, getting new financing, or even selling the business. But if those options aren’t available, then yes, a bankruptcy might keep you from losing everything you’ve built. Get a small business lawyer who knows how to handle business bankruptcy to help you out.
