Chapter 13 Bankruptcy for Small Businesses: An Overview

If you're a small business owner struggling with debt, Chapter 13 bankruptcy may help you reorganize your debts and save your business.

Filing for Chapter 13 bankruptcy might help you reorganize your debts and save your business—but only in a few specific instances. Read on to learn more about who can use Chapter 13 bankruptcy and if it can help you and your business.

How Does Chapter 13 Bankruptcy Work?

A Chapter 13 bankruptcy allows you to keep your assets while reorganizing and paying off all or a portion of your debts through a repayment plan. The Chapter 13 repayment plan usually lasts three to five years. You make monthly payments to the bankruptcy trustee assigned by the court to oversee your case. The trustee will pay your creditors according to your plan.

How much you have to pay back will depend on your income, expenses, and the types of debt you have. The higher your income, the more you’ll be required to pay. However, certain debts (called priority debts) must be repaid fully through your plan regardless of income. These include certain taxes and domestic support obligations, among others.

If you’re unable to demonstrate that you have enough income to repay these debts in full—along with other required payments—you might not be able to reorganize through Chapter 13 bankruptcy. At the completion of your repayment plan, any remaining balances of qualifying debts will get discharged (forgiven).

Can a Small Business Use Chapter 13 Bankruptcy?

The short answer is no—Chapter 13 bankruptcy is for individuals only. But there’s a workaround if you own a business as a sole proprietor.

For example, suppose that Ava, the owner of “Ava’s Doggie Treats,” falls behind on payments to her suppliers, and she hopes to get back on track using bankruptcy. When it’s time to fill out the bankruptcy forms, she won’t be able to file under the business name, “Ava’s Doggie Treats.” However, because Ava is a sole proprietor, she can file for Chapter 13 bankruptcy under her own name, Ava Roberts, and reorganize both her personal and business debts.

Here’s why this works.

A sole proprietor isn’t a separate legal entity like other companies, such as LLCs and corporations. One of the key differences is that a sole proprietor is personally responsible for both individual (consumer) and business debts.

For bankruptcy purposes, all of a sole proprietor’s property and income is available to pay all debt—consumer and business debt alike. This unique structure gives all creditors a full and equal opportunity to get paid, thereby allowing for the reorganization of all aspects of a sole proprietor’s financial life.

Partnerships and Bankruptcy: Not a Good Mix

Technically, a partnership isn’t a separate legal entity, so it’s feasible that a partner might be able to benefit from Chapter 13 bankruptcy. However, most partners stay away from bankruptcy altogether—and with good reason. Many partnership agreements contain clauses that dissolve the business the instant one partner files for bankruptcy, which, of course, would defeat the goal of keeping the business open. Why have such clauses? When it comes to partnerships, the results in bankruptcy (especially in Chapter 7 bankruptcy) can be unexpected. For instance, if a nonfiling partner has sufficient personal assets to repay business debt fully, a savvy creditor might object to a proposed Chapter 13 repayment plan on the grounds that the creditor would receive more in a Chapter 7 case and seek to move the matter into Chapter 7 bankruptcy. Once in Chapter 7 bankruptcy, the bankruptcy trustee would likely go after the nonfiling partner’s personal assets—a result most partners actively seek to avoid.

Benefits of Chapter 13 Bankruptcy to the Sole Proprietor of a Small Business

Chapter 13 bankruptcy has features which can help keep a small business running.

Keep Business Assets

In bankruptcy, all filers can protect (exempt) certain items needed to maintain a home and employment—which is good because most sole proprietors need equipment and other types of property to function. A benefit of Chapter 13 bankruptcy is that you can keep both exempt and nonexempt property—although it comes at a cost.

  • Exempt business property. The “tools of the trade” exemption protects business-related assets up to a certain dollar value. Because each line of work has a unique set of equipment needs, most exemption statutes allow you to choose the particular property that you’ll keep, however, it must be reasonably necessary for your employment. For instance, if you work as a plumber, you’ll likely need a work truck and plumbing tools. By contrast, an accountant would probably require a computer, a software program, and a desk.
  • Nonexempt business property. If your business has nonexempt assets, Chapter 13 bankruptcy allows you to keep them while you reorganize and pay off your debts (unlike a Chapter 7 case where the bankruptcy trustee takes these assets and sells them). But keep in mind that you’ll have to pay for the value of your nonexempt assets in your plan—which can get expensive if you have a lot of valuable equipment, stock, fixtures, and the like.

You’ll look to your state’s bankruptcy exemption statutes to determine what you can protect and what you’ll have to pay for.

Wipe Out Business Debts

Again, if you are a sole proprietor, your business debts aren’t distinguished from your personal debts. You’ll include everything you owe in the bankruptcy and, like anyone else, you’ll likely pay a minimal amount on debts that aren’t secured by collateral, like credit card balances, utility bills, medical bills, and unpaid invoices. And you’ll receive a discharge of any qualifying balance when you complete your plan. After discharge, the creditor cannot collect from you or the business.

Pay Off Important Creditors

If your business has priority debts like taxes, you can pay them off in your repayment plan if you are a sole proprietor or are otherwise personally liable for them.

Cram Down Secured Loans

Through your Chapter 13 plan, you might be able to reduce the balance of certain secured debts (such as car or equipment loans) to the value of the property. This option can reduce the burden on your business by consolidating these loans into your repayment plan and lowering your monthly payments.

(To learn more, see Cramdowns in Chapter 13 Bankruptcy: The Basics.)

Using Chapter 13 Bankruptcy to Repay Business-Related Obligations

It’s common to end up personally responsible for a business debt, and you can discharge this type of debt in a Chapter 13 case.

Much of this debt occurs because new businesses aren’t profitable. Creditors know this and commonly require the person behind the business to agree to use personal assets to pay unpaid business debt (known as a personal guarantee). Individuals regularly sign personal guarantees for property leases and mortgages on commercial buildings.

It’s also common to find yourself personally responsible for unpaid business tax or debt from a dissolved partnership or sole proprietorship.

The tricky part is that most personal guarantees don’t come due until after the business fails to pay the obligation—in other words, after the company closes down—so many times, this benefit won’t help keep a business open. If, however, the business is still open, keep in mind that the bankruptcy will wipe out your obligation to pay the debt only. An operating business will remain responsible for the business obligation (to the extent it remains unpaid).

Business Chapter 7 Bankruptcy: No Income Qualification

If you’re facing a significant amount of debt after the closure of a business, you might be better off filing for Chapter 7 bankruptcy—even if you have a significant income. When you have more business debt than personal (consumer) debt, you don’t have to take and pass the means test. You can get a discharge in Chapter 7 bankruptcy—and avoid paying into a repayment plan—even if your income is quite high. Of course, you’ll still have to give up any assets that aren’t covered by a bankruptcy exemption. So this might not be a good option if you have a lot of property that you can’t protect. (More on exemptions in the “Keep Business Assets” section above.)

Consult With a Bankruptcy Lawyer

Filing for bankruptcy when you own a business has its own set of complications, many of which cannot be addressed in a short article like this. The best way to protect your interests is by meeting with a bankruptcy attorney who is familiar with both the laws of your state and the practices of the local bankruptcy court.

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