The ultimate risk faced by small business owners is not making enough money to pay off the debts that they owe. This typically results in the difficult situation of being forced to file for small business bankruptcy to receive the help required to eliminate or repay the money they owe.

This article explains the steps business owners need to take to decide whether to declare bankruptcy and how to file for it.

• Small business bankruptcy: The basics
• Types of small business bankruptcy
• Chapter 7 small business bankruptcy: Liquidation
• Chapter 11 small business bankruptcy: Reorganization
• Chapter 13 small business bankruptcy: Reorganization
• How small businesses can file for bankruptcy
• Business bankruptcy: The timeline
• Can it harm a business to declare bankruptcy?
• How does filing a business bankruptcy impact credit?
• Small business bankruptcy: The bottom line

Small business bankruptcy: The basics

Small business bankruptcy is a legal process that can happen when a business is unable to repay its debts. The bankruptcy process is handled in federal court and is governed by longstanding bankruptcy law. All decisions related to a bankruptcy case are made by a judge assigned to it. A trustee handles the management and administration of a small business bankruptcy case. The United States Trustee Program of the Department of Justice appoints the trustee.

The process for filing for business bankruptcy — and the outcomes — will vary based on your financial situation and the structure of your business.

Types of small business bankruptcy

Small businesses have three ways to file for bankruptcy, called chapters. The chapters — Chapter 7, Chapter 11, and Chapter 13 — are named based on their position in the U.S. Bankruptcy Code. 

Chapter 7 small business bankruptcy: Liquidation

Chapter 7 bankruptcy is the most common type of bankruptcy. Almost four out of five consumer bankruptcy filings are Chapter 7. This form of bankruptcy is available to consumers and all sorts of businesses. 

Chapter 7 bankruptcy is the most suitable option if you are unable to keep your company running because you can’t pay off your current business debts. The result of a Chapter 7 filing is the liquidation of the business’s assets, and the company is subsequently closed down.

When a business files for Chapter 7:

• The company shuts down.
• All of its officers, directors, and employees are dismissed.
• A court-appointed bankruptcy trustee takes over to liquidate the company to pay back creditors.

The company does not continue operating under Chapter 7, except in very few cases where the trustee allows it to do so for a short period to facilitate its closure.

If you have creditors who you haven’t paid back, the trustee will divide up your assets among them. Certain assets that fall under bankruptcy exemption laws are safe from creditors. For instance, federal and state laws typically protect a filer’s home.

Individuals who file for Chapter 7 bankruptcy need to show that their income is low enough to qualify. Business owners do not have to meet income requirements. 

Corporations, limited liability companies, partnerships, and sole proprietorships are all eligible to file for business bankruptcy under Chapter 7. However, it’s most common among sole proprietors. Once creditors are paid off and the trustee is paid, sole proprietors earn a discharge, which means the owner is no longer responsible for paying back business debt, even if you signed a personal guarantee. Other types of businesses can’t receive formal discharges. That means if you signed a personal guarantee on a business loan, creditors could come after your personal assets to pay back the debt.

Chapter 11 small business bankruptcy: Reorganization 

Chapter 11 bankruptcy allows a business to continue operating while reorganizing debts. Business owners choose this option when their finances are poor but not completely underwater. They could continue to operate effectively with help from the bankruptcy court.

In a Chapter 11 scenario:

• The company management remains in control of the business.
• It can make decisions that the court must approve.
• It emerges from bankruptcy in the form of an operating company.

The business uses the bankruptcy process to eliminate debt by selling off non-performing assets, restructuring debts, and bringing in new equity or financing.

Your small business must prove through a means test to be generating regular revenue to qualify for Chapter 11. You must submit a reorganization plan to the bankruptcy court detailing how and when you plan to repay all your debts. Your creditors and a judge must review and approve the plan.

In short, Chapter 11 provides a way to negotiate with creditors. For instance, instead of paying back your loan within its defined term, the court might allow you to make payments over a longer time.

The ultimate goal of a Chapter 11 bankruptcy is to ensure you can continue operating by getting your expenses and income in balance and helping you regain profitability over time. In many cases, business owners must participate in a debtor education session or credit counseling course to help prevent future business finance issues.

Chapter 13 small business bankruptcy: Reorganization

Chapter 13 bankruptcy is an option that individuals primarily use. However, sole proprietors are a type of business entity that can leverage it as well. Chapter 13 is very similar to Chapter 11, but small businesses can use it with a limited number of creditors. It is a simplified and less costly way for small businesses to reorganize.

There are debt limits for Chapter 13 bankruptcy. They’re currently just over $400,000 of unsecured loans or $1,250,000 of secured ones. These limits change periodically to reflect inflation and changes to the cost of living.

Under Chapter 13, a sole proprietor files for personal bankruptcy, petitioning the court to reorganize their personal and business debts. Sole proprietors must file for Chapter 13 bankruptcy under their names, not those of their companies.

Both personal and business debts are overseen by the trustee, who will treat your personal and business property in the same way. Both are available to pay back all business and personal debt.

Under Chapter 13, a sole proprietorship can continue operating through an automatic stay. As with Chapter 11 bankruptcy, you must submit a reorganization plan to the court documenting how and when you plan to repay your debts. Depending on your income, personal and business expenses, and the types of debt you have, you’ll either have to repay some or all of your outstanding debt. It is possible some debt could be discharged under Chapter 13.

Typically, under Chapter 13, you get three to five years to pay back the debt, making it a reasonable option for businesses that have a relatively small amount of debt. Firms with a more significant debt load usually opt for Chapter 11 bankruptcy.

How small businesses can file for bankruptcy

When you decide to file for bankruptcy, undertaking the process is relatively simple. Sole proprietors can file on their own. However, other types of businesses need an attorney to file. Even if you’re a sole proprietor, it’s a good idea to hire a business bankruptcy lawyer because the process of filing for bankruptcy for a small business can be long, and it’s easy to make mistakes.

Applying for bankruptcy: How it works

Launching a bankruptcy is quite simple. You fill out a form, file it, and pay a filing fee. Once the case is opened, the business must file extensive disclosures with the court. After that, company management must get used to making everything about the business public and seeking approval for anything it does.

Decide which type of business bankruptcy to file

First, you must decide which of the three types of small business bankruptcy you’re going to file.

• 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 continue to operate.
• Chapter 11 is likely the correct choice if you want to remain in business but need assistance reorganizing and affording your debt.
• Chapter 7 is right for you if you can’t afford to continue operations, your business is underwater financially, and you want to close down.

File a bankruptcy petition.

After you’ve figured out which type of bankruptcy you’re filing for, you’ll start your case by filing an official bankruptcy petition. This must be done in the jurisdiction where your principal business is located. Bankruptcy is regulated by the United States Bankruptcy Court, which has 94 jurisdictions.

Complete necessary business bankruptcy forms.

After you file the initial petition, you can expect to complete a significant amount of paperwork. Each bankruptcy comes with its business bankruptcy forms. These forms are different for sole proprietors and registered businesses.

For Chapters 11 and 13 bankruptcies — which allow you to reorganize your company — you must formally disclose your payment plan for your creditors — with the bankruptcy court. You must explain how you plan to pay them back and in what timeframe you plan to do so. You must also disclose information on your company’s business affairs, liabilities, and assets, along with tax returns.

Get reorganization approved at a confirmation hearing.

In Chapters 11 and 13, bankruptcies, your next step is to get your creditors to approve your reorganization and repayment plan. Since trust has been breached, this could be challenging and may take several meetings with them.

A confirmation hearing will then take place where your reorganization plan will be discussed. The bankruptcy court can either approve or reject the plan. If confirmed, you can continue running the company and pay back your creditors. Most courts require regular business financial reports to ensure you’re complying with the reorganization plan as approved.

This step will be different if you choose Chapter 7 business bankruptcy. The court-appointed trustee will take possession of your business assets, liquidate them, and use them to pay back your creditors. In short, once Chapter 7 bankruptcy is approved, your business will be dissolved.

Be aware: All business bankruptcy paperwork is public record. That means creditors, other businesses, and friends or family members can view all your financial information.

Business bankruptcy: The timeline

Overall, the entire bankruptcy process can take a long time and cost you a significant amount of money. Working with a business attorney can help speed up the process and prevent costly mistakes.

• A Chapter 7 bankruptcy usually winds up with a discharge managed through a U.S. trustee in four to six months.
• A Chapter 13 bankruptcy takes a similar amount of time. However, the period to pay back the debt is usually three to five years.
• A Chapter 11 bankruptcy takes significantly more time. It can include a meeting of creditors. Creditors are allowed to question the debtor in court. As a final step, creditors and the court must review and approve the reorganization plan. End-to-end, this can take more than a year.

Can it harm a business to declare bankruptcy?

In many cases, it can be the only option. However, it may take a lot for workers, customers, suppliers, and others to regain trust in a reorganized operation. This is magnified by the fact that bankruptcy records are public, and people can learn about mismanagement and mistakes that caused the company to fail.

How does filing a business bankruptcy impact credit?

In short, the impact on your credit from filing for small business bankruptcy depends on the type of business you have. If you’re a sole proprietor, there’s no legal separation between you and your business.

When you file for bankruptcy, the court can discharge your debts. However, even though you no longer have to pay them back, you’ll take a massive hit on your credit. Bankruptcies appear on your credit report for seven to 10 years. They can lower your credit score by 130 points or more. This can make it impossible to qualify for simple things like credit cards and student loans.

If your business is a registered entity, such as an LLC or corporation, there is a legal wall between you and your business.  In this case, unpaid business debts and bankruptcy should not appear on a personal credit report. However, they’ll appear on your business credit report. Another thing to consider: If you signed a personal guarantee on any business debt, the unpaid debt will be on your personal credit report.

Small business bankruptcy: The bottom line

Filing for bankruptcy through United States courts is a last resort for any struggling business. You should only file for bankruptcy if you are:

• Having significant challenges paying your debts.
• Being sued by creditors or having liens placed on necessary business equipment and real estate.
• Feeling like your company is going under. 

The bankruptcy process can help you restructure your finances and business practices. This can allow you to continue to operate your company. However, if your business is failing, the bankruptcy process might mean that your operation must be dissolved.

Small business bankruptcy must be taken seriously. The impact can last a decade or more. That’s why it’s critical to get legal advice from an experienced business bankruptcy attorney before you make any final decisions.

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