Unfortunately, one of the biggest risks associated with managing your business finances is the potential that you won’t make enough money to pay off the debts that you owe. In this case, you might make the difficult decision to file for small business bankruptcy in order to receive the help you need to eliminate your repay your debt.
What is business bankruptcy?
At a high level, small business bankruptcy is a term used to define a legal process that takes place when a business is unable to repay its debts. The entire bankruptcy process is handled in federal court, and any decisions regarding a bankruptcy case are made by an appointed bankruptcy judge. Administration of a business bankruptcy case is handled by a trustee—an officer appointed by the United States Trustee Program of the Department of Justice.
This being said, the exact process of filing business bankruptcy, and the results, vary based on your financial situation and the type of business you have.
If you’re filing bankruptcy as a small business, there are three types of bankruptcy, called chapters, that you might file for. These chapters—Chapter 7, Chapter 11, and Chapter 13, are named based on where they exist in the U.S. Bankruptcy Code.
Chapter 7 bankruptcy is the most common type of bankruptcy, making up about 80% of consumer filings. Chapter 7 bankruptcy is available to consumers and all types of businesses.
Generally, this type of bankruptcy is the most suitable option if you do not have the means to keep your company running, and are unable to pay off your business’s current debts. The result of a business bankruptcy Chapter 7 filing is the liquidation of the business’s assets and closure of the business.
Linda Worton Jackson, a partner at commercial law firm Pardo, Jackson, Gainsburg, PL explains:
“Once a business files for Chapter 7, the company shuts down; the officers, directors, and employees are dismissed; and a court appointed trustee takes over to liquidate the company for the benefit of creditors. The company does not continue operating under Chapter 7, except in very rare circumstances where the trustee allows it to do so temporarily.”
Individuals who file for Chapter 7 bankruptcy need to show that their income is low enough to qualify. Filers who are seeking to discharge business debts do not need to meet income requirements.
This being said, if you have multiple creditors who you haven’t paid back, the trustee will divide up your assets among those creditors. Certain assets that fall under bankruptcy exemption laws are safe from creditors. For instance, there are usually federal and state laws that provide some protection for a filer’s home.
A range of business entities, including corporations, limited liability companies, partnerships, and sole proprietorships are all eligible to file business bankruptcy Chapter 7, but it’s mostly a tool used by sole proprietors. Once the creditors get paid, and the trustee receives their fee, sole proprietors receive a discharge.
A discharge means that you’re no longer responsible for paying back business debt, even if you signed a personal guarantee. Corporations, LLCs, and partnerships can’t receive formal discharges, so if you’ve signed a personal guarantee on a loan, creditors can still come after your personal assets to satisfy a debt.
Next, Chapter 11 business bankruptcy allows a business to continue operating while reorganizing debts. Businesses pursue this option when they’re not completely underwater and have the potential to continue operating as a viable company with some help from the bankruptcy court.
“In a Chapter 11 bankruptcy, the management remains in control, and has the ability to make decisions for the company, with the court’s approval. When a company reorganizes, it means it will emerge from bankruptcy as an operating company as opposed to liquidation. The business will use the bankruptcy process to eliminate debt, sell off non-performing assets, restructure long-term debts, and possibly bring in new equity or financing.”
In order to be eligible for a business bankruptcy Chapter 11 filing, your company must be generating regular revenues. If you go this route, you’ll have to submit a reorganization plan to the court showing how and when you expect to repay all your debts. Your creditors and the court must review and approve the plan before it goes into effect.
Chapter 11 bankruptcy essentially allows you to negotiate with your creditors. For instance, instead of having to pay back your loan within a five-year repayment period, the court might allow you to make payments over the next 20 years.
The goal of a Chapter 11 bankruptcy is to make sure you can continue operating by balancing expenses and income and helping you regain profitability over an extended period of time.
Chapter 13 bankruptcy is an option that’s primarily for consumers, but sole proprietors can use it as well. As Jackson explains,
“Chapter 13 bankruptcy is very similar to Chapter 11, but is only applicable to small businesses with a few creditors… It is a simplified and less costly reorganization for small businesses.”
There are debt limits that determine eligibility for Chapter 13 bankruptcy. As of April 1, 2019, you can’t have more than $419,275 of unsecured loans or $1,257,850 of secured loans to qualify. These numbers change periodically to reflect inflation and the cost of living changes.
Under Chapter 13, a sole proprietor can file for personal bankruptcy and petition the court to reorganize their debts. The key thing to remember is that as a sole proprietor, you have to file for bankruptcy under your own name, not the business’s name.
Both personal and business debts come under the trustee’s purview. The trustee will treat your personal and business property in the same way—both are available to pay back all debt, business, or personal.
With this type of small business bankruptcy, the business can continue operating. As with Chapter 11, you must submit a reorganization plan to the court for approval, showing how and when you plan to repay your debt. Depending on your income, personal and business expenses, and types of debt you have, you’ll either have to repay some or all of your outstanding debt (some might be discharged).
Usually, under Chapter 13, you get three to five years to pay back the debt, so this is really only an option for businesses that have a small amount of debt. Businesses with a larger debt loan should consider Chapter 11 bankruptcy.
Thinking through the pros and cons of small business bankruptcy and deciding if it is the right option for you is something that you must give careful thought and consideration to.
Once you decide you want to proceed with bankruptcy, however, initiating the process is pretty simple. Sole proprietors can file on their own, but other businesses need an attorney to file. And even if you’re a sole proprietor, we recommend hiring a business bankruptcy lawyer, because the rest of the process of filing bankruptcy for a small business can be lengthy.
How does business bankruptcy work?
“The commencement of bankruptcy is actually simple,” Jackson says, “with a form that must be filed, along with payment of a filing fee. But, after the case is opened, the company must file very extensive disclosures with the court. After that, management must become accustomed to making its secrets public and seeking approval of every move.”
This being said, here are the basic steps required to file business bankruptcy:
First and foremost, you need to decide which of the three types of small business bankruptcy you’re going to file. As a reminder, Chapter 13 is only usually an option for sole proprietors and is suitable if you have a small amount of debt. With this option, your business can remain in operation.
Similarly, Chapter 11 will likely be your best option if you want to remain in business but need assistance reorganizing and affording your debt. Finally, business bankruptcy Chapter 7 will be right for you if you can’t afford to continue operations and need to close your business.
After you’ve determined the type of bankruptcy you’re going to file, you’ll start your case by filing an official bankruptcy petition in the jurisdiction where your principal place of business is located. Bankruptcy is regulated by the U.S. Bankruptcy Court, of which there are 94 jurisdictions.
After you file the initial petition, there’s a lot more paperwork that follows. Each type of bankruptcy has its own business bankruptcy forms, which vary for sole proprietors and registered business entities.
For reorganization bankruptcies—Chapters 11 and 13—you must formally disclose your payment plan with the bankruptcy court, explaining how you plan to pay back your creditors and over what period of time. Your forms will also include information on your company’s business affairs, liabilities, and assets.
In the case of Chapters 11 and 13, your next step will be getting your creditors to approve your reorganization statement. This is because creditors need to be able to make an educated decision regarding your proposed plan.
A confirmation hearing will then take place, where your plan for reorganization will be up for discussion. The bankruptcy court will either confirm or reject the plan. If confirmed, you can continue running the business in order to pay back your creditors. Most courts require updated financials from your business on a periodic basis, to make sure you’re complying with the reorganization plan.
Of course, this step will be different if you’ve filed business bankruptcy Chapter 7. In this instance, the court-appointed trustee will take possession of your business assets, liquidate them, and use them to appropriately pay back your creditors. This being said, once Chapter 7 bankruptcy is approved, your business will then be dissolved.
With all of this in mind, it’s worth noting that bankruptcy forms are public record, so creditors, other businesses, and curious friends or family members can look up your financial information in court.
When it comes down to it, these steps only illustrate an overview of how to file bankruptcy as a small business.
Overall, the entire bankruptcy process can take a long time and cost you a significant amount of money—which is why working with a business attorney is so important. A Chapter 7 bankruptcy usually winds up with a discharge within four to six months. A Chapter 13 bankruptcy takes a similar amount of time, although the actual period for paying back the debt is three to five years.
Business bankruptcy Chapter 11 takes the longest amount of time. Creditors are allowed to question the debtor in court, and both creditors and the court need to review and approve the reorganization plan. All told, this can take upward of a year.
Now that we’ve explained the types of business bankruptcy and how it works, let’s answer some frequently asked questions about this legal process:
Yes. Corporations, limited liability companies, partnerships, and sole proprietorships can all file for some kind of business bankruptcy. Depending on the type of bankruptcy you are filing for (Chapter 7, 11, or 13), there may be some eligibility requirements. Generally speaking, businesses file for bankruptcy when they are unable to repay their debts.
For businesses filing business bankruptcy Chapter 7, you’ll receive an “automatic stay“—which stops creditors from trying to collect wages you owe them. The bankruptcy court will then take control of your financial affairs, preventing you from selling off property without their consent.
Roughly two weeks after you file, you will attend something called a “creditors meeting,” where you will answer questions posed by your trustee about your bankruptcy filing. The trustee will then take control of your estate and look for assets to sell to pay creditors.
For those filing business bankruptcy Chapter 11 or 13, you must disclose your payment plan with the bankruptcy court, and provide information on your company’s business equity, liabilities, and assets.
Creditors must approve your reorganization statement. You’ll then attend a confirmation hearing where your plan for reorganization will be evaluated.
If the plan is confirmed, you can continue running your business in order to pay back your creditors. You’ll also have to provide the court with updated financials over time to ensure you’re complying with the reorganization plan.
Bankruptcy forms are public, so any individual, lender, or other business can find out if your company has ever filed for bankruptcy. Of course, this also means that you can research to determine if other businesses have filed for bankruptcy. To do so, you can sign up for PACER, the online-based federal court document system, and search bankruptcies records.
Additionally, you can contact the applicable local clerk’s office and review the bankruptcy documents filed there as well.
An LLC can file for Chapter 7, 11, and 13 business bankruptcy. However, LLC members are required to hire an attorney to take them through the bankruptcy process. In addition, LLC members typically vote in accordance with state law or the LLC’s operating agreement to authorize the bankruptcy filing.
Chapter 7 business bankruptcy is known as liquidation bankruptcy. When you file Chapter 7, your business will cease operations and existing assets will be sold off to pay your debt. Certain assets, like the filer’s home, are usually protected under bankruptcy exemption laws.
To file Chapter 7 bankruptcy, you need to meet certain income qualification standards. While all business entity types can file for Chapter 7, it is typically a tool used by sole proprietorships.
In short, the impact to your credit from filing for small business bankruptcy depends on the type of business you have. If you are a sole proprietor, there’s no legal separation between you and your business.
When you file for bankruptcy, the court can discharge your debts—that means that you no longer have to pay them back, but you’ll pay the price with a huge hit to your credit. Bankruptcies show up on your credit report for seven to 10 years and can damage your score by more than 130 points.
If you have a registered business entity, such as an LLC or corporation, the legal wall between you and your business means neither the unpaid business debts nor the business bankruptcy should show up on your personal credit report.
But, they will show up on your company’s business credit report. Of course, it’s important to remember that if you signed a personal guarantee on any of your business’s debt, then the unpaid debt will show up on your personal credit report.
Filing for business bankruptcy is a last resort step for any company. You should consider filing for bankruptcy only if you are having serious trouble paying your debts, are tied up in litigation with creditors, or feel like your business is hanging on by a thread.
The bankruptcy process can bring some structure to your finances and help you get through to the other side. However, if your business is really underwater, the bankruptcy process might mean that your business has to be dissolved.
Of course, it’s never a good idea to make a hasty decision to file for business bankruptcy—it will stay on your credit history for seven to 10 years and affect your access to business financing. Be sure to explore all your options and talk with a business bankruptcy attorney before deciding what to do with your business in the near future.
Priyanka Prakash is a senior contributing writer at Fundera.
Priyanka specializes in small business finance, credit, law, and insurance, helping businesses owners navigate complicated concepts and decisions. Since earning her law degree from the University of Washington, Priyanka has spent half a decade writing on small business financial and legal concerns. Prior to joining Fundera, Priyanka was managing editor at a small business resource site and in-house counsel at a Y Combinator tech startup.