Whether you’re looking for a strategy to reopen after shelter-in-place orders lift, or planning to close permanently, filing for Chapter 7 can help your small business. Because of the pitfalls inherent in a Chapter 7 business filing, however, more business owners opt to file an individual Chapter 7 case.
Find out how to keep a small business open during the coronavirus outbreak by reorganizing under Chapter 11, subdivision V by reading How Chapter 11 Can Help Small Businesses During Coronavirus Outbreak.
Not much of anything helpful happens when a small business files for Chapter 7. The court appoints a Chapter 7 bankruptcy trustee, and for a percentage of the proceeds, the trustee inventories the business property, sells it, and distributes the funds to creditors. That’s it.
Quite frankly, you wouldn’t want anything else to happen, because all other possibilities are negative, especially given that the bankruptcy trustee works primarily for creditors and the court—not so much for the debtor. Most owners find that Chapter 7 is a risky wind-down tool, at best, and that closing a business outside of bankruptcy has its advantages. Here are some specifics you’ll want to know.
If you’re surprised to learn that Chapter 7 doesn’t erase a small business’s debts, then you’re in good company. Many people are unaware that Chapter 7 treats companies and individuals differently, but it's true—small businesses aren't entitled to a debt discharge.
While receiving a debt discharge is the reason most individuals file for Chapter 7, a small business doesn’t need one. A creditor can collect from an open, income-generating company. Once the business closes, there’s nothing to take—unless someone else is liable for the debt. Keep reading.
Because the small business debt remains intact after Chapter 7, an individual’s obligation to pay the business debt remains intact, too. So unless discharged by an individual Chapter 7 or Chapter 13 bankruptcy, a partner would still be on the hook personally for any bills owed by the partnership, as would an LLC member or corporate shareholder who agreed to assume individual liability by signing a personal guarantee.
Sometimes a business owner overrun with debt would like nothing better than to shut down and reopen under another name. But doing so wouldn’t be fair to creditors, and in bankruptcy, using tactics to defraud creditors of payment is a type of bankruptcy fraud. It’s one of the reasons the law leaves the old business debt intact. A creditor who can prove that the new business is, in essence, the same old operation, can collect the old debt from the new company.
Putting a small business in Chapter 7 can be problematic because of the many ways an owner’s personal liability can increase.
A sole proprietor’s personal and business finances will always be involved in Chapter 7 (and in some cases, filing will make sense). But the outcome isn’t always so rosy for partnerships. If the business doesn’t have enough assets to pay off all business debts, the Chapter 7 trustee will look to the personal assets of the partners—essentially making the partners’ individual finances part of the case. Owners who don’t realize that losing personal assets could be a distinct possibility when putting the partnership in Chapter 7 could find themselves in for an expensive shock.
Important tip. Keep in mind that a partner who files an individual Chapter 7 will often break a clause within the partnership agreement.
In Chapter 7, a bankruptcy trustee’s goal of liquidating assets at a quick “fire sale” often doesn’t line up with an owner’s goal of minimizing personal debt liability. Owners, recognizing the benefit of receiving top dollar for assets, often choose to take on the task of selling business assets and paying creditors themselves, knowing that the more received through the sale, the less the owner will have to pay later. Plus, avoiding bankruptcy also saves trustee commissions, lawyers’ fees, and filing costs, all of which can go toward paying down the business debt—in some cases, substantially.
Whether meritorious or not, defending a lawsuit is costly, and putting a small business in Chapter 7 ratchets up the odds of being sued. All creditors receive notice of the bankruptcy. The bankruptcy case provides a readily-available forum for a disgruntled creditor to file an adversary proceeding requesting the tapping of the business owner’s personal assets for payment.
Also, bankruptcy courts are comfortable divesting people of money—it’s part of what bankruptcy courts do. A bankruptcy judge will not be shy about piercing a corporate veil to reach personal assets, or about declaring an LLC or trust a sham. Also, bankruptcy lawsuits in federal court can be more difficult for a defendant than those filed in state court, because the debtor will face opposing counsel and a trustee.
An individual (as opposed to a business) can effectively use Chapter 7 to erase personal expenses, which helps a business by lowering an owner’s salary needs and leaving more money for the ongoing business. Wiping out both personal and business debt can also help a sole proprietor operating a service-related company remain in business. Or, if a business has closed, the owner can erase a personal obligation to pay a business debt.
But these aren’t the only strategies available—another bankruptcy chapter or a nonbankruptcy alternative might be a better fit. An experienced bankruptcy attorney can advise you of the options available for someone in your unique situation.
Find out how to file for bankruptcy when quarantined during the coronavirus outbreak.