How to File for Bankruptcy as a Small Business Owner

Running a small business has its own set of challenges. When financial difficulties arise and debt becomes unmanageable, filing for bankruptcy can be a practical solution to regain control of your finances. While bankruptcy may sound intimidating, it offers a fresh start and an opportunity to rebuild your business. This guide will walk you through the process of filing for bankruptcy as a small business owner. We’ll also explore the types of small business bankruptcy, so you can better understand which option is right for you. 

What is Small Business Bankruptcy?

Bankruptcy is a legal process designed to help struggling businesses that are unable to fulfill their debt obligations. It provides a way to address their financial problems and get a fresh start. During the bankruptcy process, the business’s assets, liabilities, and financial situation are evaluated by a court. Depending on the specific type of bankruptcy filed, the business may either have its debts discharged or create a repayment plan to manage and gradually repay the debts. 

What Are the Three Types of Small Business Bankruptcy?

1. Chapter 7 Small Business Bankruptcy: Liquidation

Among the various types of bankruptcy, Chapter 7 is the most common to both individuals and businesses. This option is appropriate when a small business finds itself incapable of settling its debts and sustaining operations. In Chapter 7, the business ceases operations, employees are let go, and a trustee designated by the court takes charge of selling off the company’s assets to repay creditors. While certain assets may be safeguarded from creditors, owners may still bear liability under personal guarantees associated with business loans.

Pros of Chapter 7:

• Debt discharge: Chapter 7 bankruptcy provides a chance for business owners to eliminate most of their business debts, offering a fresh start and relief from overwhelming financial burdens.
• Faster process: Compared to other bankruptcy options, Chapter 7 bankruptcy generally resolves more quickly, allowing for a smoother transition.
• Automatic stay: Filing for Chapter 7 triggers an automatic stay, providing immediate relief from creditor collection activities such as lawsuits, garnishments, and foreclosures.
• No repayment plan: Unlike Chapter 13 bankruptcy, Chapter 7 does not require a repayment plan, relieving business owners from long-term repayment obligations.

Cons of Chapter 7:

• Income limitations: If your income exceeds the threshold set by your state or if you have disposable income, you may not qualify for Chapter 7 bankruptcy.
• Negative credit impact: Chapter 7 bankruptcy significantly affects business owners’ credit scores, making it challenging to obtain credit in the future.
• Potential loss of assets: Nonexempt property may be sold to repay creditors, which could mean relinquishing valuable assets, although it is uncommon in Chapter 7 cases.
• Co-signer liability: Chapter 7 bankruptcy only relieves the business owner’s debt, leaving co-signers still responsible for the debt.

2. Chapter 11 Small Business Bankruptcy: Reorganization

When a business faces financial difficulties that are severe but not insurmountable, Chapter 11 bankruptcy comes into play. This option allows the business to continue its operations while undertaking a comprehensive restructuring of its debts. In Chapter 11, the existing management retains control, but all decisions must receive court approval. The primary objective is to eliminate debt through strategies such as selling underperforming assets, restructuring liabilities, and obtaining fresh financing. To qualify for Chapter 11, the business must demonstrate a consistent stream of revenue, and a detailed reorganization plan must be submitted and sanctioned by both creditors and the court.

Pros of Chapter 11:

• Business continuity: Chapter 11 allows the business to continue operating while restructuring debts.
• Debt reorganization: Chapter 11 provides an opportunity to negotiate and restructure debts, including reducing the amount owed and obtaining more favorable repayment terms.
• Asset protection: The automatic stay prevents creditor collection actions, giving the business time to protect its assets.
• Potential for profitability: Chapter 11 allows businesses to develop a feasible repayment plan, potentially leading to long-term profitability and financial stability.

Cons of Chapter 11:

• Complex and costly process: Filing for Chapter 11 bankruptcy involves the need for specialized professionals and can result in significant expenses.
• Loss of control: Business owners may experience limited decision-making power as major decisions require approval from the court.
• Lengthy timeline: Chapter 11 cases can extend over several months or even years, leading to uncertainty and disrupting normal business operations.
• Reporting and disclosure requirements: Small businesses must comply with strict obligations to provide comprehensive financial information to the court and creditors.
• Credit and reputation impact: Public records of the bankruptcy filing can have a negative impact on the business’s credit rating and reputation, potentially making it more challenging to secure future financing and business opportunities.

3. Chapter 13 Small Business Bankruptcy: Reorganization

Although Chapter 13 bankruptcy is mainly used by individuals, sole proprietors can also benefit from this option. It offers a simplified and more affordable solution for small businesses with a limited number of creditors. In Chapter 13, a sole proprietor files for personal bankruptcy, requesting the reorganization of both personal and business debts. The trustee oversees the management of both personal and business assets to repay all outstanding debt. Under the protection of an automatic stay, the sole proprietor can continue operating their business. They must present a reorganization plan to the court, outlining how they will repay their debts. Typically, the repayment period spans from three to five years, and depending on factors like income, expenses, and the nature of the debt, some obligations may be discharged.

Pros of Chapter 13:

• No means test requirement: Unlike Chapter 7 bankruptcy, Chapter 13 does not require you to pass a means test, making it accessible to individuals with disposable income and significant debt.
• Asset retention: Chapter 13 bankruptcy enables you to retain your personal property and assets, as long as you commit to making payments.
• Affordable debt repayment: Chapter 13 allows you to create a repayment plan where you can pay off your debts in smaller, more manageable amounts over a period of three to five years, often with lower interest rates.
• Consignor protection: Chapter 13 provides protection for cosigners by halting creditor collection efforts, relieving them of payment obligations, stopping delinquency reporting, and terminating their responsibility for the debt if your repayment plan covers it.

Cons of Chapter 13:

• Lengthy process: Chapter 13 payment plans typically last between 3 to 5 years, requiring a longer commitment before debts are discharged.
• Regular disposable income requirement: Sufficient regular income is necessary to contribute to the monthly payment plan, including specific debts such as tax obligations and mortgage arrears.
• Discharge upon completion: Discharge of debts is granted only after the completion of the payment plan, and failure to make monthly payments can result in case dismissal and re-collection of all debts.
• Credit Implications: Chapter 13 bankruptcy still negatively affects credit, which can impact future creditworthiness and financing options for the business.

How To File Bankruptcy for Small Business

Filing for bankruptcy as a small business can be a complex process. Here’s a simplified guide on how to navigate it:

1. Evaluate and decide. Thoroughly assess your financial situation and determine if bankruptcy is the most suitable option for your small business. Take into account factors like the amount of debt, income, assets, and the potential impact on your credit.

2. Choose the right bankruptcy chapter. Understand the different bankruptcy chapters and their requirements. Seek guidance from a bankruptcy attorney to select the appropriate chapter for your unique circumstances.

3. Complete credit counseling. Take a credit counseling course from an approved agency before filing, which explores alternatives to bankruptcy and provides financial education.

4. File the bankruptcy petition. Prepare and submit necessary legal documents to the bankruptcy court, including schedules of assets, liabilities, income, expenses, and a financial statement.

5. Automatic stay. Once filed, an automatic stay goes into effect, legally halting creditor actions like collections, lawsuits, foreclosure, and wage garnishment.

6. Meeting of creditors. Attend the meeting of creditors, also known as the 341 meeting, where you will answer questions under oath about your finances. While creditors may be present, the meeting is typically conducted by a bankruptcy trustee.

7. Asset evaluation and debt discharge. In Chapter 7, the trustee evaluates your assets, selling non-exempt ones to repay creditors. In Chapter 11 and Chapter 13, you create a repayment plan to partially repay debts over several years.

8. Complete a financial management course. After filing, fulfill the requirement of taking a financial management course from an approved agency.

9. Debt discharge. Once you successfully complete the bankruptcy process, eligible debts are either discharged (Chapter 7) or restructured and partially repaid (Chapter 11/ Chapter 13), giving you a fresh start.

Should You Hire A Bankruptcy Attorney?

We highly recommend hiring a bankruptcy attorney when filing for bankruptcy. While it is possible to file on your own, the bankruptcy process can be complex, and navigating the legal requirements can be challenging. A bankruptcy attorney knows the laws and can guide you through the process, explain your options, and make sure you meet all the legal requirements. They can also communicate with your creditors and work to get the best outcome for you. Having a lawyer by your side increases your chances of a successful bankruptcy case.

Should You File for Bankruptcy?

Filing for bankruptcy should be your last resort if your business is struggling. Only choose bankruptcy if you’re facing significant difficulties in paying debts, dealing with creditor lawsuits or liens on your business assets, and seeing your business’ survival at risk.  Keep in mind that bankruptcy has long-lasting effects, so it’s essential to seek advice from an experienced bankruptcy attorney to make informed decisions.