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If you’re thinking about filing bankruptcy for your small business, you’ll have plenty of questions about what kind of bankruptcy you’re eligible for and what might make the most sense for your business.
This is a big decision to make, with lots of considerations. To help, here are answers to some pressing questions on this fraught subject.
Key Points
• Small business bankruptcy options include Chapters 7, 11, 12, and 13 of the U.S. Bankruptcy Code, each with specific eligibility requirements and implications.
• Chapter 7 involves liquidation, allowing sole proprietors to address personal and business debts.
• Chapter 11 allows reorganization, suitable for LLCs, corporations, and partnerships to restructure finances.
• Bankruptcy for businesses can impact personal credit, especially for sole proprietors, affecting credit scores significantly.
• The business’s structure determines liability for debts; sole proprietors are liable, while LLCs and corporations generally protect personal assets.
What Are the Different Types of Bankruptcy for Business Owners?
Within the U.S. Bankruptcy Code, the types of bankruptcy for businesses are Chapters 7, 11, 12, and 13.
There are other types, but they’re not for small business bankruptcies. Chapter 9 bankruptcy applies only to municipalities: cities, counties, school districts, and so forth. Chapter 15 bankruptcy rules facilitate international legal processes when bankruptcy proceedings filed in foreign countries involve U.S. financial interests.
You may hear the term insolvency used when talking about small business and bankruptcy. This means a person is unable to pay debts due to lack of funds but may not necessarily be going bankrupt.
Bear in mind that insolvency and illiquidity are not the same thing. A business that is illiquid is generally facing short-term cash flow issues, but would probably be able to access working capital through loans, equity financing, or restructuring company operations.
Recommended: What Is Insolvency?
Chapter 7 vs. Chapter 11 vs. Chapter 13 Bankruptcy
This chart sums up some of the important features of the three most common types of bankruptcy so that you can see them all together.
| Chapter 7 | Chapter 11 | Chapter 13 | |
|---|---|---|---|
| What Does It Do? | In a “liquidation” bankruptcy, your assets will be sold (“liquidated”) and the money used to pay your creditors. | In a “reorganization” bankruptcy, you may be able to stay in business, but will need to provide a plan for reorganizing your finances and repaying your debts. | Also called a “wage earner’s plan,” this bankruptcy type allows individuals with a regular income to keep their property and pay off their debt over three to five years. |
| Who’s Eligible? | Individuals and small businesses | Individuals, LLCs, corporations, and partnerships | Individuals and sole proprietors |
| Pros? | Sole proprietors can handle both personal and small business bankruptcies in one filing.
For LLCs and corporations, the trustee provides a transparent way to liquidate. |
No debt or income requirements.
Extended payment terms are available. Disposable income does not have to be turned over to a trustee. |
Assets can be kept while you repay some or all of the debt.
You can pay down prioritized debt, reduce some loans, and use this restructuring to catch up on other qualifying payments. |
| Cons? | As financial assets are sold off to pay creditors, the business is likely to close.
Business owners might not get the best price on assets sold during bankruptcy proceedings. |
Complex proceedings make this an expensive process. | Not available for business owners other than sole proprietors
Repayment plan may be challenging to sustain Payments will be required for three to five years. |
Key Considerations Before Filing for Bankruptcy
There are many angles to examine before you take the step of filing for bankruptcy. Your particular situation will affect your priorities. Still, the most important issues are likely to be the type and amount of debt you have. You’ll also want to consider your business’s income, assets, and goals.
Thinking these over will help you decide whether to file and, if so, which type of bankruptcy would be best for your predicament. Most individuals file for Chapter 7 or Chapter 13 bankruptcy. Businesses that intend to remain operational generally opt for Chapter 11, with some exceptions.
Assessing Business Viability and Future Revenue
Insufficient revenue or unmanageable debt may mean that your business has begun to falter. The market for your goods and services might have changed, the economy might be slumping, or trends might simply have veered in a direction you didn’t foresee. Maybe you’re suddenly wondering how to file business bankruptcy, even if you don’t go through with it.
Ask yourself these questions:
• What is the realistic outlook for the business in the near future and in the long term?
• Is it time to shutter your business altogether and make a fresh start?
• Or do you want to remain operational while discharging and restructuring your debts?
Take a look at your financial statements for this year and compare them to past numbers. It may be very helpful to analyze the outlook with your accountant and, if warranted, your lenders.
Exploring Alternatives Like Debt Restructuring or Settlement
You may be able to avoid small business bankruptcy by modifying your debt obligations. There are several methods to consider.
Debt restructuring is a common move to ward off bankruptcy. This is likely to be more helpful to you if your company’s loans have high interest rates. The comparatively steep APR on unsecured business loans, for example, means that renegotiating the terms of your loan could make a noticeable difference.
If your main issue is illiquidity, you may be able to free up some cash with a debt consolidation loan that would lower your monthly payments.
Debt settlement is similar but generally involves paying a creditor less than you owe in exchange for wiping the slate clean. Typically you or a representative of your business negotiates with creditors to determine how much of a discount they’re willing to accept. It’s wise to discuss this option at length with your attorney and accountant, who can help you steer clear of unscrupulous, fee-driven debt settlement firms.
If your business’s tax debt is dangerously high, you may want to look into the IRS’s “offer in compromise” arrangement. Eligible taxpayers (including some employers) can negotiate with the agency to settle an overdue tax bill for a smaller sum than what’s owed. If the offer is accepted, the taxpayer can submit a lump sum or agree to a payment plan.
For business owners eyeing a Chapter 7 bankruptcy filing, there is yet another approach to consider. Assignment for the benefit of creditors (ABC) is a state-governed, voluntary alternative process in which a business transfers its assets to a trust, after which they are liquidated to pay creditors. ABC can be quicker and less formal than federal bankruptcy proceedings. This option is available in more than 30 states.
How Bankruptcy Affects Employees and Business Operations
Regardless of whether you choose Chapter 7, Chapter 11, or Chapter 13, small business and bankruptcy can be a painful combination. Businesses heading into bankruptcy often have to contend with employee retention, skittish suppliers, unhappy customers, and more. Here’s some information you may want to consider.
Managing Payroll and Contracts During Bankruptcy
The Bankruptcy Code sets out legal requirements and priorities for managing payroll and contracts during the bankruptcy process.
If the company is going out of business, employees have a priority claim on wages and benefits that were earned up to 180 days before the bankruptcy filing; the allowable amount tops out at just over $15,000. Employers also have an obligation to pay payroll taxes on those wages.
If the company has 100 or more full-time workers, the employer is bound by the federal Worker Adjustment and Retraining Notification (WARN) Act, which requires 60 days of advance notice about layoffs or plant closures. Several states, including California, New York, and Illinois, have their own versions of this law.
Legal obligations during bankruptcy may involve modifying or rejecting contracts with court approval. Companies can either continue or terminate contracts that haven’t been completely fulfilled, including employment contracts.
Continuing the contracts calls for the business to make good on defaults and show it can perform in the future. Termination may allow employees to file damage claims.
Communicating with Stakeholders
If your business is a sole proprietorship, you may not have many stakeholders in the roles of employees and investors. But every business has clients and vendors, and many also have consultants, landlords, lenders, and gig workers. Those people all have at least a small stake in your enterprise. Larger businesses may have thousands of stakeholders involved in the purchase, production, sales, and distribution of their products or services.
Be transparent and humane with your stakeholders as bankruptcy looms on the horizon, corporate communications experts advise. What you tell them will depend on the type of bankruptcy you’ve decided to pursue.
Chapter 11, for example, doesn’t usually mean a company is shutting down, so in talking to worried employees, be specific about how the company will resolve its financial and legal issues and continue to operate.
You may even find someone who’s willing to infuse some capital by investing in your bankrupt company as it reorganizes under Chapter 11.
The main goal in all cases is to demonstrate good faith by addressing and talking over your customers’, partners’, and workers’ concerns.
The Takeaway
When a small business struggles — and sometimes can’t even service its small business loans — it’s understandable that an owner would wonder about filing for bankruptcy. There are at least three types of bankruptcy structures that can be viable ways to protect the business and reorganize financial obligations. It’s very important to choose the type of bankruptcy that fits with your needs and priorities.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
Are you personally liable for your business debts?
The answer depends on what kind of business structure your company has. If you are a sole proprietor, you can be held liable for your business debts. If your company is an LLC or corporation, you are generally separated from the company and cannot be held liable. In partnerships, general partners are typically liable, while limited partners typically are not, but this can vary by state.
How will the bankruptcy affect your personal credit?
If your business is an LLC or a corporation, it should be legally separate from you, so the business’s bankruptcy should not affect your personal credit (unless you have signed a personal guarantee). However, if you are a sole proprietor, there is no separation and bankruptcy, which can stay on your credit report for seven to 10 years, depending on what type it is, can lower your personal credit score significantly.
How will this affect your business credit?
If your business survives the bankruptcy, there will still be a negative impact on your business credit score.
What happens if a business files for bankruptcy?
If a business files for Chapter 7 bankruptcy (liquidation), the company’s assets will be sold by a trustee, the proceeds will be disbursed to the creditors, and the business will cease to exist. If the business files for a Chapter 11 bankruptcy, it will be able to keep doing business but will have to pay off some or all of its debts according to a structured repayment plan.
Who can file for Chapter 7 bankruptcy?
Individual people can file for Chapter 7 and so can businesses. Small business owners are able to choose whether to file on their own personal behalf or on behalf of the business.
Who can file for Chapter 13 bankruptcy?
Individuals with a regular source of income. Among small businesses, only sole proprietors can file for Chapter 13, so this is not an option for corporations or LLCs.
Who can file for Chapter 11 bankruptcy?
This type of business bankruptcy is available for individuals, as well as for LLCs, corporations and partnerships.
Photo credit: iStock/elenaleonova
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