If you’re a struggling small business owner—especially a sole proprietor—filing for Chapter 7 bankruptcy could help you save your service-related business or provide a simple way to close it. It’s rare to put any other type of business in a Chapter 7 bankruptcy—such as a partnership, LLC, or corporation—because it’s usually not beneficial. The business won’t receive a debt discharge, and filing for bankruptcy can increase other liabilities, such as a lawsuit to pierce the corporate veil.
Instead, most people who’ve signed personal guarantees agreeing to pay for partnership or corporate business debt usually choose to wipe out their individual liability by filing for Chapter 7 bankruptcy in their own name.
(If you’re considering filing for bankruptcy yourself, but you aren’t sure which type would be best, start by reading What Are the Differences Between Chapter 7 and Chapter 13 Bankruptcy?)
The answer depends largely on the structure of your business or if you’ve signed a personal guarantee. A personal guarantee is an agreement that you’ll pay the business debt personally if the business fails to do so.
If you’ve signed a personal guarantee, you’re liable for the debt regardless of the business structure. Otherwise, your liability will depend on the business type.
If you’re a sole proprietor, you and your business are treated the same, so you’ll be able to discharge all qualifying debt by filing a Chapter 7 bankruptcy in your own name. If you have more business debt that personal debt, you likely won’t need to worry about how much income you make—you won’t need to pass the Chapter 7 means test.
You can protect both personal and business assets by using bankruptcy exemptions. So with a Chapter 7, it’s possible to wipe out your debts and continue operating the business. Because most states allow you to keep a modest amount of property—basically, the bare necessities—this works best when you have a service-oriented business, such as if you’re a personal trainer or accountant.
People who own businesses that require costly equipment, goods, and supplies—such as a restaurant or clothing store—might have a difficult time retaining the business after filing for Chapter 7. The Chapter 7 trustee appointed to oversee your case would sell any nonexempt property, which in many cases, would make it impossible for the business to continue. In fact, the trustee might attempt to sell the business itself, if possible.
A partnership is a separate legal entity and can file a Chapter 7 business bankruptcy. When the partnership files for bankruptcy, there is no discharge of the business debt. Also, the partners can’t use exemptions to protect property. The trustee will close and liquidate the business by selling it or all its assets to pay creditors.
In a general partnership, all partners are personally liable for the business debt which can cause a problem if the partnership files for bankruptcy. If there aren’t enough business assets to pay off all creditors, the bankruptcy trustee (or the creditors) could go after the personal assets of each partner to satisfy any outstanding obligation.
In most cases, it’s better for the individual partners to each file for Chapter 7 bankruptcy (in their own names—not the business name) and discharge both personal and business obligations.
Similar to a partnership, a corporation can also file a Chapter 7, but it won’t receive a discharge. The benefit of a business Chapter 7 is the simple and orderly liquidation it provides by placing the burden of selling assets and paying creditors on the trustee instead of the owners.
It’s rare for the benefit to outweigh the risks of this bankruptcy type, however. For instance, any stockholder who cosigned or personally guaranteed a corporate debt will still be on the hook for the debt (unless the shareholder files a Chapter 7 in his or her own name). Most corporations would do better selling the property at a higher price (compared to fire sale bankruptcy prices) and negotiating down the debt with creditors. This would leave less financial burden on those responsible for the corporate debt.
Also, filing for bankruptcy gives creditors an easy forum to claim that the officers failed to follow corporate formalities—an action called piercing the corporate veil. Winning this type of lawsuit has the effect of making shareholders liable for the corporate debt.
An LLC works almost precisely the same way as a corporation when it comes to bankruptcy and debt liability. You can liquidate the business by filing a business bankruptcy, but you must wipe out your liability for business debts through personal bankruptcy. Also, the same risks apply.
(To learn more about what happens when your business files for Chapter 7, see Chapter 7 for Small Businesses.)
Each case is unique. Before moving forward with a business or personal bankruptcy, you'll want to find out which bankruptcy type will best meet your needs. A bankruptcy attorney can review the facts of your case, then explain your options and the ramifications of each choice. Also, most attorneys will consult with you free of charge.