Keeping a small business going for the long haul can be a difficult task. Studies show that one in five small businesses don’t make it 24 months; nearly half (45%) close within five years; and about two-thirds (65%) fail within 10 years. If your business is facing hard times, a bankruptcy filing can help you either get a fresh start or make the dissolution of business operations easier.
Bankruptcy is a legal procedure, available under federal law, whereby a business can get some protection from creditors and may be able to work out new payment arrangements that allow it to continue operations without pressure or harassment from creditors. When you seek bankruptcy protection for your business, you’ll work directly with the U.S. Bankruptcy Court, which serves as an intermediary between you and your creditors. Upon filing for bankruptcy protection, you and your business have the immediate protection of the automatic stay, which prohibits creditors from calling, sending letters, visiting you, filing a lawsuit, or taking any other action to collect on your debt except through the bankruptcy proceedings.
The two common types of business bankruptcy are under Chapter 7 and Chapter 11 of the U.S. Bankruptcy Code. There are other unique forms of bankruptcy protection, such as Chapter 12, which applies only to family farmers and fishermen.
Chapter 7 bankruptcy, also referred to as “liquidation,” allows a debtor to relinquish property to the bankruptcy court to reduce or discharge debt. Most businesses that seek to discharge debt through bankruptcy are sole proprietorships. Partnerships, limited liability companies (LLCs), and corporations can file under Chapter 7, but the process has fewer benefits. For example, a sole proprietor may fully discharge a debt in Chapter 7, but a partnership, LLC, or corporation may remain liable for any balance due to a creditor if the bankruptcy sale does not fully pay off the debt. Additionally, a partnership, corporation, or LLC cannot designate property as exempt from the bankruptcy estate. Note, however, that if liquidation does not pay off the entire debt of an LLC or corporation, the members or shareholders of the company are shielded from personal liability.
If you file for Chapter 7 protection as a sole business proprietor, the same rules that apply to consumers will generally govern your bankruptcy proceeding; however, both your business and personal assets may be liquidated. (Technically, a sole proprietor files a personal bankruptcy petition because there is no legal distinction between the person and the business.) You must qualify to file by submitting to a means test. Furthermore, some debts are dischargeable—child support arrearages, most tax debts, and student loan payments. You may claim certain property as exempt. If you’re able to claim enough exemptions, you may be able to reduce your debt while keeping some assets and staying in business.
If you meet the requirements to file under Chapter 7, you can typically discharge your debts and start over again in four to six months.
Chapter 11 is essentially the business version of a Chapter 13 consumer reorganization. When you file for protection under Chapter 11, you’ll need to put together a list of all your creditors and what you owe them. You’ll then be required to put together a plan to repay your creditors, which must be submitted to the court and your creditors and must be approved by both. Your creditors may, if they choose to reject the proposed plan, submit their own plan to the bankruptcy court. Ultimately, the bankruptcy court determines what the repayment plan will be. The court also has the discretion to determine that Chapter 11 isn’t feasible and either dismiss the case or convert it to a Chapter 7 liquidation proceeding.
A proposed reorganization plan may involve reduced interest rates, suspension of payments for a period of time, or even the discharge of some debt. It’s fairly common that the plan involves some “downsizing” of the debtor’s operations, so as to minimize costs and make more assets available to pay creditors.
Since 2020, certain sole proprietors and small businesses have had the option of Subchapter V, which was created by the Small Business Reorganization Act. Subchapter V proceedings are less expensive and more streamlined than other Chapter 11 bankruptcies, offering benefits to small businesses. To qualify for Subchapter V, a business must have no more than $2,725,625 in debt.
When a business seeks protection under Chapter 11, it generally means that the owners want to continue business operations, seeking only to lessen the burden until the company’s fortunes improve. The primary objective with a Chapter 11 bankruptcy is to return the company to financial health.
With most Chapter 7 filings, the business will either be dissolved or recreated as an entirely new entity. The overarching goal, with a Chapter 7 petition, is generally to minimize potential losses for all parties. As noted above, though, in some cases, a sole proprietor may be able to claim enough exemptions under state or federal law to discharge debt and continue business operations.
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