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 using Chapter 11, Subchapter V, the reorganization bankruptcy created to meet the needs of small businesses. Learn more in Chapter 7 vs. Chapter 11 Bankruptcy and filing for bankruptcy in 2022.
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. However, here's the catch. 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.
Instead, 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 the business owner's individual responsibility to pay personal guarantees and other business debts.
By contrast, sole proprietors can discharge business and personal debt in the same Chapter 7 bankruptcy case.
Learn more in Chapter 7 for Small Business Owners: An Overview.
Whether your company will benefit from Chapter 7 often depends on the business entity type.
If you are a sole proprietor, Chapter 7 can give you the financial relief you need by wiping out personal and business debts in a single bankruptcy case. Another benefit? If your business debts exceed your personal debts, you won't need to meet the income requirements of the Chapter 7 means test.
Also, you don't lose all your property because you can use bankruptcy exemptions to protect personal and business assets. Sole proprietors who own service-oriented enterprises don't usually need much equipment or inventory, so they benefit most from Chapter7. Not only can they wipe out debt, but they tend to retain enough equipment to continue operating the business.
However, the reverse is also true. Chapter 7 doesn't work well for sole proprietors who require substantial property. Because the Chapter 7 trustee will sell nonexempt property, if you can't protect necessary equipment and products, Chapter 7 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 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.
It's important to note these entities rarely file for Chapter 7 for several reasons. The most basic include that it's more cost-effective to sell business property outside of bankruptcy, and staying out of bankruptcy can help minimize litigation. Also, Chapter 7 is rarely a good idea for partnerships because of the risk of the trustee paying business debt with the partners' personal assets. Keep reading for more drawbacks.
For more information, see Are You Personally Liable for Business Debts?
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.
Also, 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.
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.
Plus, putting a business in bankruptcy opens the door 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.
Only individuals can file for Chapter 13 bankruptcy. Business entities such as partnerships, corporations, or LLCs don't qualify for Chapter 13. However, sole proprietors can file Chapter 13 and reorganize personal and business debts.
Also, if you're a business owner, Chapter 13 will be worth considering if freeing up funds by reorganizing personal debt would be enough to keep the company afloat. A bankruptcy attorney with business-related experience can help you determine the best overall strategy.
In Chapter 13, you pay all or a portion of your debts through a three- to five-year repayment plan. Not only can you wipe out your personal liability for business debts with Chapter 13, but the tools available in Chapter 13 allow you to solve problems that Chapter 7 can't help, such as:
The company itself will be an asset, and business interests usually aren't covered by exemptions, although a "wildcard" exemption might provide some protection. The point is that you'd need to pay the business's value through the plan, possibly increasing the monthly required payment to an unaffordable amount.
By contrast, you'd have even fewer options in Chapter 7 bankruptcy. Why? Because a Chapter 7 trustee will always sell property that isn't protected by a bankruptcy exemption. Chapter 7 filers don't have the option to keep nonexempt property that they need to keep the business going by paying its value over five years.
Chapter 13 takes much longer than Chapter 7 because you must make monthly payments to a trustee for three to five years, and, as discussed above, Chapter 13 payment plans can be expensive. Also, a Chapter 13 discharge wipes out personal liability for business debt, and the business will remain responsible for paying back its obligations.
Learn more in Chapter 13 Bankruptcy for Small Businesses: An Overview.
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