Chapter 7 vs. Chapter 13 for Small Business Owners

Most small business owners want to know whether bankruptcy will help them continue their business, and in many instances, the answer is yes. Filing for bankruptcy can help a struggling small business survive and even thrive. But whether you'll choose Chapter 7, 13, or 11 bankruptcy to help you continue your business will depend on the following:

• what the company does
• the business structure
• the company's debts and assets, and
• whether the business's income can fund a repayment plan.

Read on to learn about factors to consider when determining whether a Chapter 7 business bankruptcy, Chapter 13 bankruptcy, or Chapter 11, Subchapter V can help you save your business or wind it down in an organized manner.

What Happens When a Business Files for Bankruptcy?

It depends. Businesses are limited to filing either Chapter 7 or 11, but sometimes it's possible for a business owner, rather than the business itself, to use Chapter 13 effectively. Before diving into the details, it's a good idea to familiarize yourself with these basics.

• Businesses in Chapter 7 bankruptcy. Chapter 7 is a "liquidation" bankruptcy. The trustee appointed to the case sells property and disperses the proceeds to creditors. Almost all businesses that file for Chapter 7 bankruptcy are closed when they file or shut down during the process. Chapter 7 is the quickest and most cost-effective bankruptcy type.
• Businesses in Chapter 11 bankruptcy. Chapter 11 is a "reorganization" bankruptcy. You and your creditors create a plan to pay bills in a manner that allows the company to remain operational. Chapter 11 is lengthy and costly. Chapter 11, Subchapter V is a cheaper, more efficient version available to small businesses.
• Owners in Chapter 13 bankruptcy. Chapter 13 is also a "reorganization" bankruptcy, but other than sole proprietors, businesses can't file for Chapter 13 because it's intended for individuals. Chapter 13 can help an owner reduce personal debt, such as credit card balances, which can help a business stay open.

But businesses don't file for bankruptcy as often as believed, especially not Chapter 7. Instead, business bankruptcy lawyers often help business owners use a bankruptcy filing more strategically. It's due to the limitations of bankruptcy, and the pros and cons of each chapter.

To illustrate this, we've outlined important points in the "When a Business Files for Bankruptcy" chart below. Consider referencing the chart while reading about your bankruptcy options.

"When a Business Files for Bankruptcy" Chart

This chart outlines primary points to consider when determining whether you or your company should file for bankruptcy, but it doesn't address all issues. The best way to protect your assets is by consulting with a business bankruptcy lawyer.

Should You or Your Business File for Bankruptcy?

The most beneficial chapter for you or your business will depend primarily on whether you want to close or keep the company open. If unsure, start by reading "Continuing Your Business: Factors to Consider" below.

Otherwise, if your business has closed or will close, continue reading. Skip to the Chapter 13 and 11 sections if you want to keep the business open.

If you're a sole proprietor with a service-oriented company, be sure to read "Sole Proprietors Benefit Most From Chapter 7 Business Bankruptcy."

Can Individuals and Businesses File for Chapter 7 Bankruptcy?

Yes, both individuals and business entities can file for Chapter 7 bankruptcy. Small business owners can put a company in Chapter 7 or personally file a Chapter 7 case.

What Happens When a Business Files for Chapter 7?

In most cases, filing a Chapter 7 bankruptcy will close the business. Why? Because there's no way to protect property owned by a separate legal entity like a corporation or limited liability company (LLC). The trustee sells the business assets, pays its creditors, and shuts the business down.

Also, when a company files Chapter 7, the company's debt doesn't get wiped out or "discharged." Because it remains intact, a company's bankruptcy does nothing to lessen the owner's personal liability for the business debt.

The exception to this rule? When a service-oriented sole proprietor files for Chapter 7 (more below).

How a Business Can Benefit From Filing for Chapter 7 Bankruptcy

If your business is a corporation or limited liability company (LLC), Chapter 7 bankruptcy provides a way to close down and liquidate the company transparently. When these companies file for Chapter 7, it becomes the bankruptcy trustee's responsibility to sell off the business's assets and pay its creditors.

Why Small Businesses Rarely File for Chapter 7 Bankruptcy

Unless you're a sole proprietor filing bankruptcy, your business won't receive a discharge of its debts in Chapter 7. So, if you're somehow responsible for the business debt, for instance, you signed a personal guarantee, you'll still be on the hook unless you file an individual Chapter 7 bankruptcy.

A few other things to consider:

• A business entity can't use exemptions to protect assets in business bankruptcy. The trustee sells all business assets to pay creditors, and the business shuts down.
• Most owners can wind down a business without help, avoiding the additional cost of a bankruptcy attorney and filing fees.
• In most cases, a business owner can get a better price for the business assets and pay a more significant share of the business debt, leaving less debt for an owner to pay through a personal guarantee.
• A Chapter 7 bankruptcy puts partners' personal assets at risk.
• Putting a business in bankruptcy opens the door to litigation involving fraud or a partnership dispute, or for creditors to lodge objections or claim officers didn't follow corporate formalities and members or shareholders should pay business debt with personal assets. To learn more, see Piercing the Corporate Veil: When LLCs and Corporations May Be at Risk.

Because of these reasons and more, it's essential 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.

Learn more in Chapter 7 for Small Business Owners: An Overview.

Sole Proprietors and Business Owners Benefit Most From Chapter 7

Service-oriented sole proprietors who would like to keep a business open and business owners whose company has closed benefit most from Chapter 7 bankruptcy.

How Business Owners Benefit From Personally Filing Chapter 7

Many business owners choose to file a personal bankruptcy after a business closure. It's often more effective because it accomplishes most business owners' fundamental goals of erasing their responsibility to pay personal guarantees and other business debts.

For more information, see Are You Personally Liable for Business Debts?

How Service-Oriented Sole Proprietors Benefit From Chapter 7

Filing a Chapter 7 bankruptcy rarely works to a business owner's advantage, except for sole proprietors providing a specific service. Here are the benefits Chapter 7 offers to service-oriented sole proprietors.

• Because a sole proprietor is responsible for both personal and business debts, you can wipe out both types in a single Chapter 7 case.
• If your business debts exceed your personal obligations, you won't need to meet the income requirements of the Chapter 7 means test (this rule applies to all individuals filing for Chapter 7).
• Service-oriented businesses, such as accountants, freelance writers, or fitness trainers, often survive Chapter 7 because the bankruptcy trustee can't sell your ability to perform the service.
• Service-oriented sole proprietorships also don't need much equipment or product that could be lost in bankruptcy.
• Sole proprietors can use bankruptcy exemptions to protect the relatively minor assets associated with a service-oriented business.

As a result, Chapter 7 is an attractive option for sole proprietors with little or no business assets. It will wipe out the business debts and allow the owner to continue providing the service and keep the business running.

To learn more about Chapter 7 bankruptcy, how exemptions work, and what happens to your debts and property, see Chapter 7 Bankruptcy.

When a Sole Proprietor Should Avoid Chapter 7

If you're a sole proprietor who needs equipment or property to run your business and want to keep your business open, a Chapter 7 bankruptcy might be a bad option.

Almost all states protect some business property with exemptions, but the amount varies widely. Because the Chapter 7 trustee will sell nonexempt property, if you can't preserve necessary equipment and products, Chapter 7 could put you out of business.

Can I Keep My Business If I File for Chapter 13 Bankruptcy?

Yes, filing for Chapter 13 could help you keep your business, but you'd need to file personally because only individuals and sole proprietors qualify for Chapter 13. Partnerships, corporations, and LLCs can't file.

What People Who Own Businesses Can Expect in Chapter 13 Bankruptcy

Chapter 13 takes far longer to complete than Chapter 7 because you'll make a monthly payment for three to five years. But there's a positive side to Chapter 13's payment plan. Most people pay more toward obligations they value and less toward credit card balances, medical bills, and personal loans.

For instance, Chapter 13 filers can:

• catch up on a house, car, or collateralized credit account and save the property
• pay off bills over time, such as tax debt and domestic support obligations, and
• reduce some secured loans to the property's value using "lien stripping" or a "cramdown."

However, because of these benefits, Chapter 13 payment plans can be expensive, and not everyone has enough income to pay the required amount. You must pay for some debts in full in Chapter 13.

And, the amount you pay your unsecured creditors—those with bills other than your mortgage, car payment, and other collateralized debt—must equal or exceed the value of "nonexempt assets" or property you can't protect with bankruptcy exemptions through your repayment plan.

But this chapter doesn't work the same for sole proprietors and other business owners. You'll find a brief overview of the main differences below.

Chapter 13 Differences Sole Proprietors and Other Business Owners Should Expect

In Chapter 13 bankruptcy, sole proprietors list and protect business-related assets differently than other business owners and can include business debt as part of the Chapter 13 case. Here are the mechanics.

Business Property

• Sole proprietors will list the value of all business and personally owned property, not the company's value. Sole proprietors can protect business-related property using the "tools of the trade" and "wildcard" However, suppose you owned $150,000 in nonexempt construction equipment. In that case, you'd pay creditors $2,500 per month for five years plus other required amounts.
• Other business owners will list all property they own, including the value of the business. Bankruptcy exemptions don't often protect company ownership, but a wildcard exemption might be available. For example, assume your business interest is worth $150,000, but you couldn't exempt it. You'd pay creditors $2,500 per month for five years plus other required amounts.

Business Debts

• Sole proprietors will include business and personal debt and can erase qualifying business and personal debt.
• Other business owners will include personal debts in Chapter 13, including personal guarantees, but the businesses will remain responsible for paying back obligations.

In both cases, valuable property poses a problem when the property isn't covered by an exemption, possibly increasing the monthly required payment to an unaffordable amount.

Learn how to calculate a Chapter 13 payment and more about Chapter 13 bankruptcy for small businesses. If you have any questions, a bankruptcy attorney with business-related experience can help you determine the best overall strategy.

All Businesses in Chapter 11 Bankruptcy

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 company keeps its assets and pays creditors through a repayment plan. However, a straight Chapter 11 t is usually a lot more complicated when compared to a Chapter 13 bankruptcy because the business must file continuing operating reports, and creditors must approve the plan. It's also prohibitively expensive for most small businesses.

Fortunately, small businesses can now use Chapter 11, Subchapter V, a relatively new bankruptcy reorganization that's easier and cheaper because it's more like Chapter 13. To learn more about bankruptcy for your small business, see Small Business Bankruptcy.

Learn more about Chapter 7 vs. Chapter 11 Bankruptcy.

Continuing Your Business: Factors to Consider

You'll want to consider several things before continuing or closing down your business. Here are a few critical considerations.

• Is the business making money? You started your business to make a profit. If your business consistently loses money, closing shop could be the right option. However, suppose you own a profitable company facing temporary economic challenges. In that case, staying operational and weathering the storm might make sense. However, it's essential to be realistic about remaining open. Entrepreneurs tend to be optimistic and often funnel money into a venture long after it's time to pull the plug.
• Are the business assets worth more than its liabilities? It's pretty evident that if your business has more assets than liabilities and is still making money, it might be worth saving. Reorganizing debt in bankruptcy (or eliminating it if you're a sole proprietor) might be needed to keep the business afloat. If the solutions offered by bankruptcy aren't feasible, consider closing the business by liquidating the property and paying off the business debt outside of bankruptcy (unless you'd like the Chapter 7 bankruptcy trustee to do it for you in a transparent manner—but be sure to consider the potential downfalls discussed below). In most cases, you'll save money and generate more funds for creditors. On the other hand, if the business is severely upside down, you likely already know it might be time to cut losses.
• Are you personally liable for business debts? If you're personally on the hook for your company's debts, keeping it running while negotiating with creditors might be more advantageous. Closing the business might leave creditors with no other option but to go after your personal assets if the company doesn't have enough assets to cover its liabilities. Another common approach is for the business owner to file an individual Chapter 7 bankruptcy and wipe out the personal guarantee.

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.

When Creditors Force Your Business 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.

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 prefer to 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 must share proceeds with other creditors, taking a smaller portion or, in some cases, getting nothing at all.

However, it's essential to understand 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 creditors are willing to take the risk and return the funds if necessary.

The involuntary process begins in the same manner as a voluntary action—official bankruptcy forms get filed with the court. If you'd like to learn more, read Involuntary Bankruptcy.

Need More Bankruptcy Help?

Did you know Nolo has been making the law easy for over fifty years? It's true—and we want to make sure you find what you need. Below you'll find more articles explaining how bankruptcy works. And don't forget that our bankruptcy homepage is the best place to start if you have other questions!

We wholeheartedly encourage research and learning, but online articles can't address all bankruptcy issues or the facts of your case. The best way to protect your assets in bankruptcy is by hiring a local bankruptcy lawyer.