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Small Business Bankruptcy: A Helpful Guide

Filing for bankruptcy can be a scary thing for small business owners. But sometimes, it’s the only option to save your business. This article will walk you through the basics of small business bankruptcy in a simple, conversational way. We’ll look at the different types of bankruptcy, pros and cons, and things every small business owner should know.

What is Small Business Bankruptcy?

Bankruptcy is a legal process that allows you to resolve debts you can’t pay. It involves filing a petition in federal bankruptcy court and following court-approved debt repayment or debt discharge plans. The goal is to get relief from creditors and emerge with a fresh start.

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There are a few main types of bankruptcy for small businesses:

  • Chapter 7 – Total liquidation of assets to pay creditors. The business closes.
  • Chapter 11 – Reorganization plan to stay open and repay debts over time.
  • Chapter 13 – Repayment plan for sole proprietors to catch up on debts.

The type you choose depends on whether you want to stay in business or close up shop.

Should You File for Bankruptcy?

Filing for bankruptcy is a big decision that requires careful thought. Here are some signs it may be the right choice:

  • You’re behind on vendor payments or taxes
  • Lawsuits are piling up from unpaid debts
  • Revenue can’t cover regular bills
  • Creditors keep calling about late payments

If this sounds familiar, meeting with a bankruptcy attorney is a smart next step. They can review your finances and advise if bankruptcy makes sense.

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Pros of Small Business Bankruptcy

Here are some potential benefits if you file bankruptcy:

  • Stop creditor harassment – The automatic stay stops collections calls and lawsuits.
  • Catch up on debt – Chapter 13 lets you repay debt over 3-5 years.
  • Lower expenses – You can reject expensive contracts and leases.
  • Keep operating – Chapter 11 allows you to reorganize and stay open.

The right chapter can help struggling businesses get back on their feet financially.

Cons of Small Business Bankruptcy

There are also some downsides to be aware of:

  • Costs money – Attorney and court fees add up, usually $5k-$10k.
  • Hurt credit – Personal credit scores will drop 100+ points.
  • Stigma – Some vendors won’t work with bankrupt companies.
  • Uncertain outcome – Reorganization plans can still fail.

While bankruptcy provides relief, it can also do lasting damage. Be sure the benefits outweigh the costs for your situation.

Chapter 7 Bankruptcy

Chapter 7, also called liquidation, is the most common type of small business bankruptcy. It involves closing down the company and using proceeds from selling assets to pay creditors.

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Any assets exempt from creditors are retained. This includes:

  • Up to $25,150 in equity in your home
  • $3,775 in equity in a car
  • $12,625 in household goods and clothing
  • Tools of your trade up to $2,525

The court appoints a trustee to oversee liquidating company property and distributing payment to creditors. The trustee also investigates your finances for improper activity.

If there are no assets to liquidate, creditors get nothing. Qualifying business debts are legally discharged or wiped out. However, you’re still responsible for certain debts like taxes and fraud.

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Most small businesses don’t have many sellable assets. So Chapter 7 results in simply closing up shop once debts are discharged.

Who Should File Chapter 7?

Chapter 7 works best for businesses that:

  • Want to close the company
  • Have more debt than assets
  • Have little inventory or equipment to sell
  • Need a fast solution

It provides a relatively quick way to resolve debts and make a fresh start.

Chapter 11 Bankruptcy

Chapter 11, known as reorganization bankruptcy, allows you to restructure finances and continue operating. You propose a repayment plan to creditors showing how debts will be managed.

To start, you (the debtor) gain exclusive right to propose a reorganization plan. This plan divides creditors into classes and says how each will be paid. It must be approved by holders of two-thirds of the debt in each class.

After filing Chapter 11, you become a “debtor in possession” – allowed to operate the business under bankruptcy court supervision. But the court can appoint a trustee to take over if there are signs of fraud or gross mismanagement.

While in Chapter 11, you can reject expensive leases and contracts. Pre-bankruptcy debts can be paid back over time, often at reduced amounts. Assets aren’t liquidated.

If creditors approve the plan, debts are restructured according to those terms. If the plan fails, creditors can force liquidation under Chapter 7. On average, the Chapter 11 process takes 6 months to 2 years.

Who Should File Chapter 11?

A Chapter 11 reorganization can help businesses that:

  • Have valuable assets they want to keep
  • Wish to stay open under a debt repayment plan
  • Have debts exceeding $2,725,625
  • Need time to improve cash flow

It offers a chance to renegotiate terms and emerge stronger than before. But the plan must be viable for success.

Chapter 13 Bankruptcy

Chapter 13 bankruptcy is only for sole proprietors or independent contractors. It allows individuals to restructure personal and business debts under a 3-5 year repayment plan.

Like Chapter 11, you make monthly payments to creditors following a court-approved plan. These payments come from your income, not sold assets. Creditors must stop all collection efforts during this time.

To qualify for Chapter 13, you must have regular income and limited debts. As of 2022, you can’t owe more than $419,275 in unsecured debts or $1,257,850 in secured debts.

In return for completing the repayment plan, you get a discharge of remaining debts. However, any missed payments can get your case dismissed, eliminating the discharge.

Who Should File Chapter 13?

Chapter 13 helps sole proprietors that:

  • Have regular income to make payments
  • Want to keep assets like a home or car
  • Need time to catch up on debts
  • Have debts below the Chapter 13 limits

It provides an alternative to Chapter 7 or 11 for individuals who wish to pay back debts over time.

The Bankruptcy Process

Filing bankruptcy involves several steps, including:

  1. Meet with an attorney – Discuss options and prepare paperwork.
  2. File a petition – Submitted to bankruptcy court with forms and fees.
  3. Automatic stay – Creditors must stop collections once filed.
  4. 341 meeting – You meet with creditors and a trustee.
  5. Submit repayment/reorganization plan – Chapter 11, 12, 13 only.
  6. Discharge – Court eliminates eligible business debts.

The process takes 3-6 months for liquidation under Chapter 7. Chapters 11 and 13 take much longer due to repayment plans.

Alternatives to Bankruptcy

Before deciding to file bankruptcy, be sure to explore alternatives like:

  • Debt consolidation loan – Combines debts into one payment.
  • Debt settlement – Negotiating directly with creditors.
  • Selling assets – Generate cash quickly from inventory, equipment, etc.
  • Business loans – Inject cash to cover expenses and debts.

While bankruptcy provides important protections, it also comes with long-term consequences. Weigh all options carefully beforehand.

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