When a small business flounders, owners begin exploring ways to get the business back on track—and while filing a business bankruptcy can be helpful, it might not offer the solution you’d expect.
For instance, most business owners are surprised to learn that company debt doesn’t get discharged (wiped out) in a Chapter 7 bankruptcy—and that sometimes filing for bankruptcy can cause more problems than it solves. That’s not to say that bankruptcy won’t offer relief, but that before filing, you’ll want to do your research and consult with a knowledgeable bankruptcy attorney.
Bankruptcy affects different types of businesses in drastically different ways, and because of this, you can expect that the first question a bankruptcy attorney will ask you will be whether your business is a:
Next, you’ll be asked whether you’d prefer to wind down the company or keep it going through a restructured payment plan. Only after obtaining this information will the attorney be able to outline your options so that you can decide the best course of action.
Because a sole proprietor is personally responsible for all business debt, the individual and business are essentially the same when it comes to bankruptcy. As a result, the entire financial situation of both will be included in the case. Interestingly enough, this structure affords a sole proprietor more solutions than any other type of organization.
A Chapter 7 case will wipe out the individual’s responsibility to pay qualifying business debt (as opposed to the business debt itself), as well as personal debt (including personal guarantees—more below). The downside is that the assets of both the individual and the business get included in the bankruptcy estate, too.
The filer won’t lose everything, however. The filer can protect a certain amount of property with a bankruptcy exemption. The remaining nonexempt property will get sold for the benefit of the creditors.
Whether or not the company stays open after the bankruptcy will largely depend on the type of business engaged in. For instance, a dog walking company would likely remain viable because of its service-oriented nature.
By contrast, a business that relies heavily on equipment or product, such as a food truck catering service, would probably end up defunct after the bankruptcy. It would be highly likely that the bankruptcy trustee—the individual responsible for overseeing the case—would have the right to sell the truck and food preparation equipment and distribute the sales proceeds to the creditors. With necessary equipment gone, the business would, in most cases, cease to exist.
An additional benefit of filing as a sole proprietor is that if the majority of bills are business debts, the filer won’t have to take the Chapter 7 means test—the financial test that determines whether an individual qualifies for a Chapter 7 discharge. Therefore, having a significant income won’t preclude many sole proprietors from receiving a discharge.
Find out about the 341 meeting for Chapter 7 business filers.
A sole proprietor is the only type of business entity that can take advantage of Chapter 13 protection. (That isn’t to say that an individual who owns a business can’t file a Chapter 13 case—the debtor can file an individual case, but the business and its debts won’t be included in the bankruptcy.)
Assuming that the total debt doesn’t exceed the chapter limits and that the company has sufficient income to support a plan, the filer might be able to keep the business open while making payments to creditors over a three- to five-year period.
This chapter has the added benefit of allowing the filer to catch up on personal bills at the same time. For instance, if the owner kept the business afloat by using funds usually allocated for a mortgage payment, this chapter would not only stop the impending foreclosure but allow the filer to catch up on the past-due payments.
If the total debt amount is too high (debt limits exist in Chapter 13 bankruptcy), the filer can pursue a Chapter 11 case; however, the attorneys' fees required are often too prohibitive for many small businesses.
Most partnerships have two options—a Chapter 7 or Chapter 11 bankruptcy. Because a Chapter 7 bankruptcy doesn’t discharge the business debt, in this scenario, it’s only useful if the owners want to wind down a closing or closed business in a transparent manner.
In that case, the trustee would take over the responsibility of selling the business assets and distributing the funds according to bankruptcy priority law. This approach affords creditors a greater degree of confidence in the debt payment process. In other words, they’ll be more likely to believe that they’re getting the amount that they’re entitled to receive.
However, this chapter comes with a significant problem for individual partners, and because of it, partnerships rarely file for Chapter 7 bankruptcy.
Here’s the problem: Because partners are responsible for the business debt, filing puts the partner's personal assets at risk. Specifically, the trustee could—and very well probably would—take each partner’s individual property, sell it, and use the proceeds to pay down the company debt. And, to add insult to injury, the bankruptcy wouldn’t wipe out any of the individual’s personal debts, either.
On the other hand, if a partnership wants to keep the business open, filing for Chapter 11 bankruptcy might be a good option. The company would develop a plan to repay its debts—quite possibly at a discount.
The same basic rules that apply to partnerships will also apply to a limited liability company or a corporation. There’s one exception, however. Because of the shield that this type of business structure provides to members and shareholders, the personal assets of the owners usually aren’t at risk.
There’s a caveat, however. If a principal improperly handled business assets—for instance, by using them for personal purposes—someone who believes that they’ve been harmed (the “plaintiff”) might choose to bring an alter ego action to “pierce the corporate veil.” If the plaintiff wins, the principal’s personal assets might be at risk in the bankruptcy case.
Once the matter is in the bankruptcy arena, it is relatively easy to bring the alter ego action. Therefore, if there's a possibility of this type of litigation—even if there’s a possibility of unwarranted litigation—the corporate officers should think twice before putting the business in bankruptcy and providing a convenient forum for an alter ego lawsuit. All lawsuits are expensive, no matter what the outcome might be.
It’s important to understand that a business bankruptcy will not wipe out a personal obligation to pay a company debt—often called a “personal guarantee.” To do so, you’ll likely need to explore filing an individual bankruptcy.
A large part of deciding whether bankruptcy is a good fit for a business entails understanding the impact. Specifically, you’ll want to know what will happen to the organization’s assets, whether it will be feasible to continue operating the company, and your personal liability risk.
Because a business bankruptcy involves many moving parts—too many to cover in this article—it’s important to meet with a knowledgeable bankruptcy lawyer to discuss your particular situation.
