Chapter 7 vs. Chapter 13 for Small Business Owners

Not sure which type of bankruptcy is best for your small business? Learn the pros and cons of Chapter 7 and Chapter 13 bankruptcy.

Most small business owners want to know whether bankruptcy will help to continue a business. The answer is yes, but the options will depend on the structure of your company, how much debt and assets you have, and whether you intend to continue running the business. Read on to learn more about the pros and cons of Chapter 7 and Chapter 13 bankruptcies for small businesses and when you can use each.

If you want to keep your company open, consider another avenue, that of using Chapter 11, Subchapter V—the modified reorganization bankruptcy created to meet the needs of small businesses. Learn more in Chapter 7 vs. Chapter 11 Bankruptcy.

Who Can File Chapter 7 Bankruptcy?

Both individuals and business entities can file for Chapter 7 bankruptcy. Small business owners have the option of filing Chapter 7 on behalf of their business or for themselves personally. If you're a sole proprietor, both your business debt and your personal debt will be resolved in the same Chapter 7 bankruptcy case.

Filing for Chapter 7 bankruptcy on behalf of the business doesn't wipe out any debt whatsoever, however. So many business owners choose to file an individual bankruptcy after a business closure because of the ability to erase the individual's responsibility to pay a personal guarantee and other business debt.

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

Benefits of Chapter 7 Bankruptcy for Small Business Owners

If you are a sole proprietor, Chapter 7 allows you to wipe out both personal and business debts in a single bankruptcy case. If your business debt exceeds your personal debts, you won't have to meet the income requirements of the Chapter 7 means test.

Also, you can use bankruptcy exemptions to protect your personal and business assets. So, in some cases—for instance, if you have a service-oriented business that doesn't need much in the way of equipment or inventory—you can continue to operate the business after wiping out business debts in bankruptcy. If, however, you can't protect all of the property you need to run your business, the Chapter 7 trustee will sell the nonexempt property, which could put you out of business.

If your business is a corporation, or limited liability company (LLC), Chapter 7 bankruptcy provides a way to close down and liquidate your company in a transparent manner. When you file Chapter 7 on behalf of your business, it becomes the bankruptcy trustee's responsibility to sell off the assets of the business and pay its creditors.

Keep in mind that Chapter 7 is rarely a good idea for partnerships because of the risk of the trustee paying debt with the personal assets of the partners. Keep reading for more drawbacks.

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

Drawbacks of Chapter 7 Bankruptcy for Small Businesses

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 a personal Chapter 7 bankruptcy.

Also, a business entity can't use exemptions to protect assets in business bankruptcy. As a result, the trustee sells all of the business assets to pay creditors, and the business gets shut down.

In most cases, a business owner can get a better price for the business assets, and thereby pay down a more significant share of the business debt. This will leave less debt to be paid by the owners.

Plus, putting a business in bankruptcy opens the door for creditors to lodge objections or to claim that corporate formalities weren't followed and that the 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.

Who Can File for Chapter 13 Bankruptcy?

Only individuals can file for Chapter 13 bankruptcy. Business entities such as partnerships, corporations, or LLCs cannot do so. However, if you are a sole proprietor, you can file a personal Chapter 13 to reorganize your personal and business debts. And sometimes reorganizing personal debt is enough to help a business owner keep the company afloat. A bankruptcy attorney with business-related experience can help you determine the best overall strategy.

Advantages of Chapter 13 Bankruptcy for Small Business Owners

In Chapter 13, you get to keep all your assets and pay back all or a portion of your debts through a repayment plan. If you are a sole proprietor with a lot of business assets, a Chapter 7 trustee may sell them if you don't have adequate bankruptcy exemptions to protect the property.

By filing a Chapter 13, you can protect all business assets and keep the business running while reorganizing your debts. Keep in mind, however, that you must pay the value of nonexempt assets (property you can't protect with bankruptcy exemptions) through your repayment plan, which can pose a problem if your ownership interest in the business is substantial.

Even if your business is a separate entity like a partnership, corporation, or LLC, you can reorganize (and potentially wipe out) your personal liability for business debts with a Chapter 13. Further, you can do things with a Chapter 13 that you can't in Chapter 7, such as:

  • catch up on a house, car, or equipment payment (any credit account wherein you used the property as collateral)
  • pay off priority creditors, such as tax debt and domestic support obligations, and
  • reduce some loans to the value of the property (called a "cram down").

Best yet, you'll get up to five years for your plan.

Disadvantages Of Chapter 13 Bankruptcy for Small Business Owners

The first and foremost disadvantage to Chapter 13 is that business entities cannot file Chapter 13. Also, Chapter 13 takes much longer than Chapter 7 because you have to make monthly payments to a trustee for three to five years.

If you have nonexempt assets—property that you can't protect with an exemption—you can keep the property, but you must pay an amount equal to its value to unsecured creditors which can increase your plan payments significantly. You might not have sufficient income to pay the required plan amount.

Further, your discharge wipes out only your personal liability for business debts. The business itself will remain responsible for paying back its debts.

To learn more see, Chapter 13 Bankruptcy for Small Businesses: An Overview.

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