The Personal Bankruptcy Option When Going Out of Business
Filing for personal bankruptcy can help you get rid of most of your liability for the business and personal debt tied to the business you're closing and give you a fresh start. The most common type of bankruptcy that small business owners use when they close a business is Chapter 7 bankruptcy, also called "liquidation" bankruptcy.
Overview of Chapter 7 Bankruptcy for Business Owners
In a Chapter 7 bankruptcy, you ask the bankruptcy court to wipe out your debts, and in return, you might have to let the bankruptcy court sell some of your personal or business property and use the proceeds to settle the debt. An individual Chapter 7 bankruptcy typically takes three to six months to move through federal bankruptcy court and generally costs less than other types of bankruptcy.
Whether Chapter 7 personal bankruptcy will solve your business debt problems depends on a combination of factors, including the legal types of debt you have, how your business is legally organized, and the nature and amount of the personal assets you hope to protect.
For starters, if you are sole proprietor, you and your business are one and the same, so personal bankruptcy will erase your personal and business debts. If you are the owner of a corporation or LLC, a personal bankruptcy won't erase your business debts, but it will remove your personal liability for them, which is the most important consideration. (For information on Chapter 7 business bankruptcy, for corporation and LLCs only, see our article on Chapter 7 business bankruptcy.)
Let's take a closer look at how Chapter 7 personal bankruptcy works.
Are You Eligible for Chapter 7 Bankruptcy?
Although individuals have to meet certain financial criteria to be eligible for Chapter 7 consumer bankruptcy, business owners whose debts are primarily due to business operations don't have to.
But if the majority of your debts (51% or more) are not from your business, you must meet the Chapter 7 financial eligibility criteria. If this is your situation, to determine whether you can file for Chapter 7, you measure your income for the last six months against the median income for a family of your size in your state. If your income is below your state's median income, it's assumed you don't have enough income to repay your debts and you can file a Chapter 7. To give you an idea, the median annual income in the United States for a family of four ranges from about $53,000 in Mississippi and New Mexico to $99,000 in Connecticut, Maryland, and New Jersey.
If your income is more than the median, you have another hurdle to clear, called the "means test," which is designed to determine whether you have enough disposable income, after subtracting allowed expenses and required debt payments, to repay at least a portion of your unsecured debts over five years (in a Chapter 13 bankruptcy).
In our experience, very few entrepreneurs whose businesses are so troubled that they are contemplating bankruptcy fail the means test. But if for some reason you don't pass, you are limited to using Chapter 13 bankruptcy for your debts.
Finding median income figures and the means test. To determine whether you pass the means test (and to find the monthly income in your area), use our free means test calculator at www.legalconsumer.com/bankruptcy/nolo. Enter your zip code and then scroll down and enter your family size.
What Happens to Your Personal and Business Property
The biggest downside to Chapter 7 is that you may have to give up some property. If, despite your business's money problems, you still have a significant amount of property you own free and clear, including investments, real estate, vehicles, or business assets, the bankruptcy trustee will take at least some of it, sell it, and distribute the proceeds to your creditors.
However, if you have few personal assets, or you owe a lot of money on them, you aren't likely to lose much. And in any case, you will get to keep the basic necessities of life, including clothing, furniture, possibly a vehicle, and some or all of your equity in your house, depending on your state's laws. Now let's look at what you're likely to lose, if anything.
The bankruptcy trustee has the power to take valuable business equipment and supplies and sell them for cash, to at least partially repay your creditors. However, most states let you keep a couple of thousand dollars worth of tools or equipment—called the "tools of the trade" exemption—if you will continue to use them to make a living. And again, some states give you a lump sum exemption (called the wild card exemption) to use for any type of property, including business property, up to a total of $20,000 or $30,000.
Having your business set up as a corporation or LLC won't protect your business assets if you file personal bankruptcy—if you are the sole owner of your corporation or LLC. The bankruptcy trustee can simply take over your shares or membership interest and vote to sell or liquidate the business and distribute the proceeds to the business's creditors. In deciding whether to dissolve the corporation or LLC, the trustee will take a cost/benefit approach: The trustee will look at the cost of dissolving and liquidating the business, how much the assets can be sold for, and whether you can claim any exemptions in the assets. In many cases, the business's debts are equal to or close to the value of the business's assets, so the trustee decides liquidating the business wouldn't be worth it. But if the business has little debt and some valuable nonexempt assets, it's likely that the trustee will dissolve the corporation or LLC and sell the assets.
If you put your house up as collateral for a business loan or line of credit, and you default on that loan—or if you stop making mortgage payments on the house—the lender can foreclose. Bankruptcy can delay the foreclosure for a while, but ultimately, if you don't make the payments, you'll lose your house.
But what about debts not tied to your house? To determine whether your house might be sold to pay debts to your landlord, suppliers, or any other business obligations, you need to understand how your state's "homestead exemption" works. Most states let you keep your principal residence if your equity in it doesn't exceed a certain limit (and, of course, you keep making mortgage payments). In other words, it can't be taken by creditors or by the bankruptcy trustee to pay your debts. In Texas, Florida, and a few other states, your residence is exempt no matter how much it's worth. In most states, only $10,000 to $50,000 of your equity is exempt from creditors. However, in a few states, such as Tennessee, Ohio, Maryland, Kentucky, and Alabama, the homestead exemption is $5,000 or less, and in New Jersey and Pennsylvania, it's zero. (Note that the homestead exemption applies only to main residences, not second houses, vacation houses, or rental property.)
If the amount of equity you have in your home is less than your state's exempt amount, there's no equity for the trustee to take. You'll be able to keep your house—assuming you keep up on your mortgage payments after the bankruptcy. But if the equity you have in your home is worth significantly more than the exempt amount, the trustee in a Chapter 7 bankruptcy will want to sell the house, give you the exempt amount (which in most states you can continue to protect by investing it another house), and use the rest of your equity to pay off your creditors.
EXAMPLE: Nathan's New York adventure travel company fails owing a $60,000 small business loan. Because the company was a sole proprietorship, Nathan is 100% personally liable for its debts, and he files for Chapter 7 personal bankruptcy. Because he has more consumer debts than personal debts (he owes $8,000 on credit cards and $245,000 on his house), Nathan is required to take the Chapter 7 means test. He passes it easily because for the last six months his income has been low and his expenses high.
Nathan's house is worth $300,000, giving him $55,000 in equity. In New York, $50,000 of home equity is exempt from being taken to pay creditors. The bankruptcy trustee could sell the house, give Nathan the $50,000 in equity that is exempt, and pay the remaining $5,000 toward Nathan's creditors. However, the trustee knows that the costs of selling the house would be more than $5,000, making it a losing proposition for the trustee, so he doesn't sell the house and Nathan gets to keep it.
Bankruptcy can buy you time. Some small business people file bankruptcy just to get some badly needed breathing room. That's because when you file for bankruptcy, the court issues an "automatic stay," an order that requires all creditors to immediately stop collection activities, including foreclosure, and prevents them from filing lawsuits or shutting off utilities. This delay might give you at least a few months to bring in the income you need to get current on your secured debts, so you can keep the collateral. After a month or two, however, secured lenders can get court permission to proceed with a foreclosure, repossession, or collection.
Your Car, SUV, or Pickup
If your car is security for your car loan, and you default on that loan, the lender can repossess your car. Bankruptcy can delay the repossession for a while—giving you an opportunity to get current—but ultimately, if you don't make the payments, you'll lose the car.
If your car isn't collateral for a debt, it still might be taken and sold by the bankruptcy trustee to pay your business debts. It depends on your state's vehicle exemption limit. Most states allow you to keep one vehicle with equity up to a certain exempt amount—usually between $1,000 and $5,000. However, some states, such as Texas, give you a lump sum exemption you can use for any type of personal property—including vehicles—up to a total of $20,000 or $30,000. (To find out your state's vehicle exemption limit, see Nolo's articles on vehicle exemptions in all 50 states.)
EXAMPLE: Jose and Jessica have two vehicles. One is a newish pickup on which they are making payments; they have no equity in it since its value went down quite a bit in the last year. The other is a ten-year-old car they own free and clear, worth $1,000.
In bankruptcy, because Jose and Jessica can't afford the payments, the pickup goes back to the lender. The amount the lender is able to sell it for doesn't cover the amount they owe on the loan plus costs, but this debt will be wiped out in bankruptcy. Because the older car is worth only $1,000, it is exempt from being taken to pay other debts, meaning Jose and Jessica can keep it.
If you bought your vehicle in the last year or two and don't have much equity in it, chances are you will be allowed to keep it after bankruptcy—if you can make the payments. On the other hand, if you have equity in your car that's worth more than your state's exemption amount (say you finished paying for your car and it's worth $12,000), you will probably have to give it up to the bankruptcy trustee. However, the trustee is likely to give you an opportunity to buy back the car at a greatly reduced price. If you decline, the trustee will sell it, give you the exempt amount, and use the rest to pay your creditors.
Don't pay off your car before you file for bankruptcy. Many people are under the erroneous impression that they get to keep one vehicle when they file for bankruptcy, so they do whatever they can to pay off their best car or truck before they file. As you can see from the discussion above, because exemption laws protect only a limited dollar amount in most states, it's better to owe money on your car when you go into bankruptcy.
Leased Vehicles or Equipment
If you want to keep paying for a leased car or other equipment, you can usually hold on to the leased property even after filing for Chapter 7 bankruptcy, by contacting the lease company and arranging to continue making the payments.
Other Valuable Assets
Every state allows you to keep a certain amount of essential personal property, such as clothing, appliances, and furniture. Even if your property is worth somewhat more than the exempt amount of personal property, the bankruptcy trustee is not likely to take it to sell, because the considerable costs of a legal sale would typically eat up the overage. However, expensive art, collectibles, boats, antiques, stocks, bonds, and highly valuable jewelry are likely to be taken and sold by the bankruptcy trustee. Fortunately, federal law exempts virtually all pensions and retirement plans from being taken in bankruptcy.
EXAMPLE: Arcelia, with her husband Alejandro's help, starts a high-end chocolaterie called Viva Chocolat! in Austin, Texas. Unfortunately, Arcelia's timing is bad, and a month after she spends $50,000 on rent, remodeling, permits, and equipment, the economy goes south. After bringing in only $1,000 her first three months, Arcelia buys her way out of her lease and closes down.
As a sole proprietor, she is personally liable for all of the business's debts. Unable to pay them, she files for Chapter 7 bankruptcy to protect their house and Alejandro's income (Texas is a community property state, so Alejandro and Arcelia are jointly liable for Arcelia's business debts). Because their debts are primarily business—$50,000 in business debts and $30,000 in personal unsecured debts—they don't need to pass the means test.
In bankruptcy, their house is entirely exempt from being taken to pay their debts, even though they have $350,000 equity in it, because the Texas homestead exemption is unlimited. They are also able to keep up to $60,000 in personal possessions—both of their vehicles, in which they have a total of $30,000 equity, and all of their furniture, art, jewelry, and family heirlooms (Texas law exempts all of these). Arcelia does have to sell the business equipment she bought to pay her business debts—they don't fall under the tools of the trade exemption since she won't continue to use them to make a living. Fortunately, federal law protects the money in Alejandro's 401(k) plan.
Debts That Can Be Discharged in Chapter 7
Not all debts are dischargeable in Chapter 7 bankruptcy, but most are. As a general rule, most business debts, including debts to landlords, suppliers, independent contractors, and equipment rental companies, plus unsecured credit card debts, unsecured loans, court judgments, and medical and legal debts, can be discharged. In addition, some taxes can actually be discharged in bankruptcy—back taxes more than three years old and the employer's portion of various payroll taxes.
The following debts are not dischargeable in bankruptcy:
- trust fund taxes (the employee's share of payroll taxes and witholding taxes)
- debts incurred to pay nondischargeable taxes (for example, if you took a loan or cash advance from your credit card to pay your trust fund taxes)
- recent back taxes and older back taxes if no tax return was filed
- recent debts for luxuries (for example, you buy a Mercedes three weeks before filing)
- cash advances of more than $825 within 70 days before you file
- loans owed to a pension plan (say you borrowed money from your 401(k) plan)
- student loans (unless repaying them would constitute an extreme hardship, such as a permanent disability that prevents you from ever working)
- court-imposed fines and restitution (money damages you owe)
- back child support and alimony, and
- debts owed under divorce settlement agreements.
In addition, if a creditor objects to the discharge of a debt on the basis of fraud, such as lying on a business loan or credit application or writing a bad check, the bankruptcy judge can rule the debt to be nondischargeable.
Codebtors will still be on the hook. A Chapter 7 personal bankruptcy discharges only your debt obligations, not those of a codebtor, such as a person who has cosigned for your loan or a business partner who is equally liable for the debt.
Other Consequences of a Chapter 7 Bankruptcy
Obviously, there's a lot to think about before you decide whether filing Chapter 7 personal bankruptcy is in your best interest. In addition to the possibility of losing property, here are a couple of other consequences that may be important to you.
Payments you made to family or friends may be reversed. The bankruptcy trustee will look at all payments and asset transfers you made during the year or two before the bankruptcy filing to make sure that you didn't make "preference" payments to certain creditors. If you made payments on a business loan to relatives or close business associates in the year before filing, or transferred business or personal property to them for little or no payment in the two years before filing, a bankruptcy court can reverse the payment or transfer. The trustee can and will "recapture" (take back) payments you made to family or friends to divide them equally between all creditors. If the money you paid to family or friends has been spent, the trustee can sue the recipient of the payment to get it back. To make things worse, if the bankruptcy judge decides you made the payment or transfer for fraudulent purposes, your bankruptcy case could be dismissed.
Your credit rating will be damaged. A Chapter 7 bankruptcy will go on your credit report and stay there for ten years. In theory, this information may hurt your chance of getting a subsequent mortgage, car loan, other credit, or possibly even a job. But in practice, if you are far over your head in debt, it's a good thing that you won't be able to immediately run up more debt (after all, you can file Chapter 7 bankruptcy only every eight years). It's also true that, if you take sensible steps to rebuild your credit and can show you have a job, many lenders will extend at least some new credit within a year or two. Keep in mind, though, that none of us yet knows what upcoming credit markets will look like.
You may need to get out of a partnership or LLC before filing for bankruptcy. If you are a partner in a partnership or a member of a multi-member LLC, you may have signed a buy-sell agreement that requires you to terminate your ownership interest before filing for bankruptcy. If you don't, you open yourself up to a lawsuit from your co-owners. A local small business attorney can help you assess your obligations and options here.
Learn more about bankruptcy for small business owners.