Filing for bankruptcy can help a struggling business survive, and even thrive. Whether you’ll choose Chapter 7, 13, or 11 will depend on what the company does, the structure of the business, the company assets, and the amount of income available to fund a repayment plan.
You’ll want to consider several things before deciding to continue or close down your business. Here are a few critical considerations.
These aren’t the only things to consider. You’ll find additional factors discussed below. (To learn about other options when your business is struggling, see Business Cash Flow Problems & Bankruptcy.)
The answer will depend largely on the structure of the business organization and the value of business assets.
In the vast majority of cases, filing a Chapter 7 bankruptcy will close the business because there’s no way to protect property owned by a separate legal entity like a corporation, or limited liability company (LLC). The trustee simply sells the business assets, pays its creditors, and shuts the business down.
But that’s not the only reason why Chapter 7 bankruptcy isn’t regularly used to close businesses. Here are a few additional problems that can crop up:
Because of these reasons and more, it’s important to seriously consider whether the risks outweigh the benefits of closing the business through bankruptcy (the primary benefit being a transparent liquidation of the business assets).
Although filing a Chapter 7 bankruptcy rarely works to a business owner’s advantage, a Chapter 7 bankruptcy might help you keep your business open if you are a sole proprietor who provides a specific service (for instance, you’re an accountant, a freelance writer, or a fitness trainer). This type of bankruptcy can be effective because the bankruptcy trustee can’t sell your ability to perform the service. Here’s how it works.
A sole proprietor is responsible for both personal and business debts. When you file the Chapter 7 bankruptcy, you’ll include all debt, and it will wipe out both types. You can also use bankruptcy exemptions to protect the relatively minor assets associated with your business (exemptions are rarely sufficient to cover businesses that require a lot of product, equipment, or goods). As a result, it is an attractive option for sole proprietors with little or no business assets because it will wipe out the business debts and allow the owner to continue providing the service, thereby keeping the business running.
Also, if you have more business debt than consumer debt, you’ll be able to file a business bankruptcy and avoid the means test (which means that your income won’t prevent you from qualifying for a Chapter 7 discharge).
To learn more about Chapter 7 bankruptcy, how exemptions work, and what happens to your debts and property, see Chapter 7 Bankruptcy.
When You’re Forced Into Bankruptcy
In most cases, bankruptcy is entered into voluntarily. But that isn’t always the case. In some situations, creditors will force a debtor into bankruptcy involuntarily.
Involuntary cases are highly unusual. Creditors use the process primarily to force a company into a business bankruptcy. It’s rarely used against an individual in a consumer bankruptcy because meeting the prerequisites necessary to file an involuntary bankruptcy isn’t easy to do. Most cases require several creditors to get together and agree to file against a debtor. If accomplished, the court appoints a bankruptcy trustee to take over all aspects of the business, sell the assets, and distribute the proceeds to the creditors.
Although this seems like it would be helpful, many creditors would rather initiate their own collection actions. By doing so, they retain the ability to grasp a larger share of the business assets. Once in bankruptcy, a creditor is more likely to have to share proceeds with other creditors and take a smaller portion, or, in some cases, get nothing at all.
It’s important to understand, however, that a creditor might not be able to keep funds collected shortly before bankruptcy—especially if it’s considered a preference claim favoring one bankruptcy creditor over another. But, many are willing to take the risk, and return the funds, if necessary.
Only individuals can file a Chapter 13 bankruptcy case. So if your business is a partnership, corporation, or LLC you cannot file Chapter 13 on its behalf.
If you are a sole proprietor, you can include both personal and business debts in your Chapter 13 bankruptcy just like you can in a Chapter 7 bankruptcy. A Chapter 13 bankruptcy might be your best option if the sole proprietorship has income coming in. You might be able to keep the business going while paying a lesser amount on both personal and business obligations that are nonpriority unsecured debt—such as credit card bills, utility payments, and personal loans.
You might run into a problem, however, if your sole proprietorship requires you to keep a lot of goods, products, or expensive equipment on hand. Although Chapter 13 bankruptcy allows you to keep your property, you still must be able to protect it with a bankruptcy exemption (and most exemptions won’t cover significant business assets). Otherwise, you have to pay the value of the nonexempt assets in the three- to five-year repayment plan. For instance, if you owned $150,000 in nonexempt construction equipment, you’d need to pay your creditors $2,500 per month, plus any other required amounts, for five years.
Because many business owners are tight on cash, keeping all the property that you need might not be feasible if you don’t have enough coming in to pay a hefty monthly plan payment.
Partnerships, corporations, and LLCs must file a Chapter 11 bankruptcy instead of a Chapter 13 bankruptcy to reorganize debts and stay in business. A sole proprietor can file a Chapter 11 bankruptcy, as well. Chapter 11 bankruptcy is similar to Chapter 13 bankruptcy in that the business keeps its assets and pays creditors through a repayment plan. However, it is usually a lot more complicated when compared to Chapter 13 bankruptcy because the business must file continuing operating reports and the plan must be approved by creditors. It’s also prohibitively expensive for most small businesses.
(To learn more about bankruptcy for your small business, see Small Business Bankruptcy.)