Filing for Chapter 7 can undoubtedly help wind down a closed business, and in a few cases, even help a company reopen along with the economy. But in either case, it's unlikely that Chapter 7 will work the way you might expect. Find out what Chapter 7 can and can't do for small businesses and the owners impacted by coronavirus closures.
Learn about the differences between Chapter 7 and Chapter 11 bankruptcy.
Chapter 7 bankruptcy doesn't reorganize company debt. It's a "liquidation" bankruptcy that shuts down a business in a transparent manner. Once filed, the Chapter 7 bankruptcy trustee appointed to administer the case investigates and inventories business property. The trustee then liquidates (sells) the assets and distributes the proceeds to creditors as required by the priority payment bankruptcy rules.
By contrast, an income-generating company with an ability to pay some but not all bills will file for Chapter 11. Chapter 11 allows the business to restructure debt payment and even reduce debt so that the company can remain open. Filing for Chapter 11 is usually cost-prohibitive, but special rules for small businesses have opened the door to more small businesses affected by the coronavirus (COVID-19) outbreak, allowing companies to remain open using Chapter 11, Subchapter V.
Learn more about Chapter 11, Subchapter V in How Chapter 11 Bankruptcy Can Help Small Businesses During Coronavirus Outbreak.
Unfortunately, many small businesses closed due to COVID-19 won't reopen along with the economy as hoped, and some owners will turn to Chapter 7 as a way to get rid of business debt. Many people don't realize, however, that a defunct business isn't entitled to a Chapter 7 discharge. So even after declaring Chapter 7, business debt remains, as well as any individual responsibility to pay the business debt (more below).
Many small businesses are further dissuaded from using Chapter 7 because doing so often increases the risk that a stakeholder will be found personally liable for business debt. Here are a few reasons why that might happen.
When the risks are coupled with the fact that the trustee gets paid a percentage of the recovered funds (thereby giving the trustee an incentive to look to the assets of an individual liable for paying the business debt) it's easy to see why putting a small business in Chapter 7 isn't palatable to most owners.
Important Tip. Chapter 7 can work well when stakeholders would prefer that the Chapter 7 bankruptcy trustee do the heavy lifting of selling the assets in the wind-down. Just keep in mind that Chapter 7 cases are rarely that simple. For more details, read Why Most Small Businesses Won't File for Chapter 7 During the Coronavirus Pandemic.
Chapter 7 can get rid of business debt, and in some cases, help a small business remain open—but it doesn't work in every situation. When it's the right fit, however, it's a cheaper and more efficient way to go.
Sometimes a small, service-oriented sole proprietor can use Chapter 7 to keep a struggling business afloat when the problem is too much debt. The debtor's own labor must be the basis of the company—for instance, an accountant, advisor, or trainer—because a trustee can't sell a debtor's future labor in a bankruptcy case. For the same reason, the business mustn't be heavily reliant on inventory, products, tools, or equipment, and the owner's personal assets should be modest. Here's why.
A sole proprietor isn't shielded from business liability the way a stakeholder is by a limited liability company or a corporation. The owner is personally responsible for the payment of both personal and business debts. So when a sole proprietor files a Chapter 7 case, both business and individual debts are subject to discharge.
Of course, this benefit comes at a cost. All of the filer's assets—business and personal alike—are available for liquidation. Even so, the filer won't lose everything.
Each state has exemption laws that protect the things a filer needs to maintain a home and employment, such as some equity in a home and car, household furnishings, a retirement account, and "tools of the trade" used in business (up to a particular value—usually between $3,000 to $10,000). Also, many states have a wildcard exemption that will protect any assets of the filers choosing, and some states let filers use the federal exemption scheme when it would protect more property.
When this works—which is more often than one might think—the small business owner will emerge from bankruptcy with significantly less debt, and in a better position to flourish when the coronavirus outbreak dies down, and the economy reopens.
Important Tip. Some bankruptcy trustees won't allow a business to stay open during a Chapter 7 bankruptcy. Others will let a company remain operational if liability insurance is in place. A local bankruptcy lawyer will know whether you'll need to close during the bankruptcy case—which typically lasts about four months.
More often than not, it's not the business that needs Chapter 7. In essence, it's whoever is personally responsible for paying business debt, such as a sole proprietor, a partner, or a member or shareholder who signed a "personal guarantee" (an agreement to pay business debt with individual assets). Creditors often require a personal guarantee before entering a credit transaction, such as financing or leasing property, with an asset-poor small business.
Because an individual Chapter 7 case will wipe out personal liability for business debt (assuming it's a type that's dischargeable), it's more common for an individual to file for Chapter 7 after the business closes than for the company to file itself. Not only is it more effective, in most cases, but it's also less risky because the outcome is more predictable (experienced bankruptcy lawyers can foresee problems with a high degree of accuracy and won't file without a viable strategy in place).
Caution. If you've secured the personal guarantee with collateral—often everything you own—and you have significant assets, this might not work unless you're comfortable losing the property. Bankruptcy exemptions won't protect property used as security in a voluntary agreement (but results could differ if the security arose from a judicial order). Also, not all debts are dischargeable. For instance, you'll remain on the hook for business-related taxes, such as employment trust fund taxes. Learn more about business debts discharged in Chapter 7 bankruptcy.
Anyone personally liable for business debt can use the following steps to assess the general viability of Chapter 7 (you'll want to verify conclusions with a bankruptcy lawyer):
Important Tip for Businesses Closed by COVID-19. You might qualify for Chapter 7 even if your company was profitable before being shut down by the coronavirus outbreak. Most filers must pass the Chapter 7 means test by showing that their income for the six months preceding the filing was equal to or less than the average state median income. However, a filer whose business debt liability exceeds their consumer (personal) debt liability doesn't need to take the means test. So if your business debt is high enough, you'll still qualify even if you brought in a substantial income recently.
While these general rules apply in many instances, bankruptcy law is complicated. Also, your small business situation is unique, and covering every factor that could affect your case is beyond the scope of this article.
Further, experienced bankruptcy lawyers can meet client goals using different avenues, such as settling debt with creditors outside of bankruptcy. And only sole proprietors can file on behalf of a business. All other small businesses must have legal representation when filing for bankruptcy. A local bankruptcy attorney experienced in small business filings will be in the best position to provide guidance—and most bankruptcy lawyers offer the first consultation free.
Find out how to file for bankruptcy when quarantined during the coronavirus outbreak.