Chapter 13 bankruptcy & Small Business Owners

Owning your own business has a lot of benefits. You’re the boss and you get to make the rules. On the downside, you take on a lot of risk, and you’re responsible for managing the books. This is doubly so when it comes to your bankruptcy filing. Read on to learn what you should know about business bankruptcy and Chapter 13.

What kind of small business do you have? 

These days, many people run their own small businesses. Whether you have a sidle hustle or run your shop full-time, you’re an owner. There are a few different ways your business can be set up. The simplest way is to be a sole proprietor. As a sole proprietor, you work alone and you don’t file papers with your state. Babysitting, mowing your neighbor’s grass, and selling Mary Kay makeup could be different types of sole proprietorships. Sole proprietorships are not separate entities.

Limited Liability Companies (LLCs) are also very common for small business owners. Their owners file papers with their state every year, and pay filing fees. You might also have a C-Corporation or S-Corporation. Each of these is a separate legal entity. With separate business entities, personal assets and business assets are separated.

Chapter 13 bankruptcy vs. Chapter 7 bankruptcy 

Individuals can choose to file bankruptcy either under Chapter 7 or Chapter 13. There are some similarities between these chapters. For example, during your bankruptcy case, there is an automatic stay. Your creditors can’t make collection efforts, including calling you or charging interest or late payment fees. Wage garnishment must stop. Beyond that, there are many differences.

Under Chapter 7, anything you own is put into a big pot. That money is divided among the people you owe money to. You may not pay back the full amount of debt. This process will take a few months. As part of your Chapter 7 case ends, most of your debts will be discharged so you won’t need to pay them.

Chapter 13 Bankruptcy works a little differently. Under this type of bankruptcy, you’ll make monthly payments from your disposable income to your bankruptcy trustee. The trustee will divide the money among your creditors. This repayment plan will last either three or five years. Unlike Chapter 7, with your Chapter 13 plan, you may end up repaying most, or even all, your debts. 

There are some rules about who is eligible for each chapter. Chapter 7 is usually only available for people whose income is below a certain point. This is called the means test. If your debt is mostly (more than 50%) business debt, you won’t need to worry about this means test.

Chapter 13 has several limitations on eligibility. Chapter 13 filers must have a regular income to support the repayment plan. However, Chapter 13 limits how much debt filers can have. If you have too much debt, filing bankruptcy under this chapter is impossible. Also, only individuals or married couples can file for Chapter 13. Chapter 13 is not available for business entities.

If you want to file bankruptcy for your business, you can use either Chapter 7 or Chapter 11. Chapter 7 shuts down your business. Chapter 11 lets you keep operating your business during the bankruptcy case. This chapter reorganizes the business during the case.

Eliminating business debt through Chapter 13 bankruptcy

Small business owners can still take advantage of debt relief through Chapter 13. The relief available changes depending on how the small business is held. Regardless of how the business is organized, Chapter 13 filers who are self-employed or own a business will have extra reporting requirements during their bankruptcy plan.

Sole Proprietors and Chapter 13

Sole Proprietors don’t separate business and personal debt on their taxes or in their bankruptcy papers. Because of this, the Bankruptcy Code lets owners of sole proprietorships lump both types of debt together. The trustee will divide the monthly plan payments among all the creditors. 

Priority debts, like personal and business taxes will be paid first and in full. Secured debts, like vehicles or furniture loans are paid second, followed by all non-priority unsecured debts, like personal and business credit cards and personal medical bills.

You’ll have to treat all the creditors equally, so you won’t be able to favor non-priority unsecured debts for your business over your personal debts. Each creditor in this category must be treated the same. However, when you finally discharge your bankruptcy at the end of your repayment plan, any unpaid portion of the non-priority unsecured debts will be gone. This is true for both your business and your personal debts.

Separate Business Entities and Chapter 13

If the small business is a separate legal entity, like a Corporation or LLC, Chapter 13 will remove the owner’s personal liability from the business debt. This means that the filer won’t be personally responsible for paying the debt. However, the business will still be responsible for paying the debt.

The Chapter 13 plan payments need to pay off priority debts of the filer. These can be the filer’s personal taxes, or child support payments, which need to be paid in full. The payments can’t be used to pay the business entity’s debts. Under Chapter 13, the filer might be able to change some secured loans, like a car loan. Using “cramdown” rules, the bankruptcy court can lower the total debt on a car to the true market value. This can reduce the total overall debt of the filer.

Even though Chapter 13 can’t be used for business bankruptcy, the filer might be able to use the plan to pay back some business debts in full over the course of their 3- or 5-year repayment plan.  Often, business owners are co-signers on business debt. This means the business owner is personally responsible for paying back a loan when the business income can’t cover it. 

For example, the owner could be a co-signer on unsecured debts for the business, like a company credit card. The owner may be able to pay all these unsecured, co-signed debts as part of their Chapter 13 plan. After the owner of a separate entity finishes their personal Chapter 13 bankruptcy case, their personal debts are discharged. Any business debt that couldn’t be included as part of the bankruptcy debt will still exist.

Other types of bankruptcies for small business owners

Small business owners can look at three other types of bankruptcies. Each different business bankruptcy has different rules for eligibility. It’s important to know how they work so you can decide what is best for you.

Chapter 7 Bankruptcy is available for some owners even if their income is too high for the means test. If more than 50% of the owner’s debts are for business debts, they don’t need to worry about failing this test. People who own sole proprietorships can file under this Chapter. Owners of separate business entities, like an LLC, can get relief from their business debts under Chapter 7 if they signed a personal guarantee on those debts.

Individuals and business owners can both file for Chapter 11 Bankruptcy. During a Chapter 11 case, the filer must submit a reorganization plan to the court. The filer may negotiate the terms of repayment with their lenders, but the creditors will vote to approve the filer’s plan. There aren’t any debt limitations in Chapter 11. There also isn’t a trustee unless the court specifically appoints one. Instead, the person who filed bankruptcy does the work of the trustee. 

Finally, Sub-Chapter 5 Bankruptcy is another option available only to separate business entities. This is a new type of bankruptcy that began in February 2020. It is similar to Chapter 11, with some differences to streamline the cases. Sub-Chapter 5 has income limitations. It also relaxes some rules about getting the creditor’s approval for the bankruptcy plan. 

Do I need to hire a lawyer to get bankruptcy relief for my small business? 

If you want to file bankruptcy for your small business, you’ll need to hire a lawyer. Individuals can represent themselves in court, but business entities can’t. Even if you’re the only person who works at your LLC, your business is legally separate from you so you must work with a bankruptcy lawyer.

It’s still a good idea to talk to a bankruptcy attorney if you don’t have a business entity, or if you want to file bankruptcy for yourself and not for your business. Chapter 13 Bankruptcy is a lot more complicated than Chapter 7 Bankruptcy. It’s not easy to work through the process on your own. Owning a business adds to the difficulty and makes the whole case a lot more complicated.

Conclusion

Small business owners have many options for managing their debts through bankruptcy. Chapter 13 has some great advantages for bankruptcy filers, but it has limited help for business owners. Because businesses can’t represent themselves in bankruptcy court, you’ll need to work with a bankruptcy attorney.