Guide to Bankruptcy Relief for Small Businesses

Small business owners who are struggling to pay the bills can often find relief, and even keep their businesses afloat, by filing business bankruptcy. But all bankruptcies are not created equal. To ensure that the outcome aligns with your goals, it is important to determine which type of bankruptcy is best for your unique situation. 

Sole proprietors

A sole proprietorship can be classified as a small business. But as an unincorporated business, run and owned by the same individual, only that individual is personally responsible for any business debts and liabilities. This is true even if the owner operates the sole proprietorship under a fictitious name. 

That being said, having no employees, and both owning and running your company does not automatically make you a sole proprietor. An individual can incorporate in this situation to separate the business entity from personal affairs. This protects the individual’s personal assets in the event of a lawsuit against the business and allows the business itself, rather than the owner, to file small business bankruptcy. 

As there is no separate entity in a sole proprietorship, the owner would file personal bankruptcy if they became financially insolvent. If you are considering bankruptcy and are unsure whether your small business is a sole proprietorship, an experienced bankruptcy attorney can help you understand your options. 

Bankruptcy for sole proprietors

As stated above, when a small business owner who is a sole proprietor decides to file bankruptcy, it is essentially a personal bankruptcy. As such, the business owner will include personal liabilities in the bankruptcy, as well as any debts incurred as part of business operations. The debtor will have the option of filing Chapter 7 or Chapter 13 bankruptcy, depending on personal income, and the total debt and the types of debt owed. Chapter 11 is also an option, but it’s rarely used by sole proprietors due to overall complexity, cost, and risk. 

To qualify for Chapter 7, the sole proprietor must pass something called the means test. This test determines whether a debtor’s disposable income is below the state’s median income, and if not, whether Chapter 7 relief is nevertheless proper. If it is, Chapter 7 is usually the preferred option as it allows the individual to discharge most unsecured debts. However, you can’t continue to operate your business if you file Chapter 7 bankruptcy. This is generally the option for sole proprietors who wish to wipe their hands clean of an insolvent business and move on to the next phase of life. A notable exception here are service-based businesses where the filer is able to protect all tools of the trade they need to operate the business with an available exemption. 

If, however, the debtor’s income is too high to qualify for Chapter 7, they  will likely file Chapter 13, which involves reorganizing an individual's or business’s debts. Instead of wiping the slate clean, Chapter 13 is based on a three-to-five year repayment plan, during which the debtor makes one, smaller monthly payment for the duration of the plan. Once the repayment period is over, most remaining debt will be discharged. To qualify for Chapter 13, the debtor must have sufficient income to handle the repayment plan, and must not have excessive secured debt or unsecured debt. The latter category includes credit cards and other types of business loans not secured by collateral. 

There are many advantages to filing Chapter 13 over Chapter 7 bankruptcy. These include: 

• You can keep your personal and business assets, including real estate and business equipment, even if they’re not exempt; 

• You can keep your business running while reorganizing your debts;

• You can catch up on back mortgage and vehicle payments, as well as payments for business equipment; 

• You can reduce the balance due on certain loans to the actual value of the property;

• You can pay priority creditors first.

And you will get up to five years to resolve these debts and rebuild your business finances. If, however, you have too much debt to qualify for Chapter 13, you may first need to file Chapter 7 to discharge your unsecured debt. Filing Chapter 7 and Chapter 13 back to back is referred to as Chapter 20 bankruptcy. 

Small businesses

In a sole proprietorship, the business and the owner are one in the same, even if the business has a fictitious name. For the purposes of bankruptcy, a small business must be a separate legal entity from the owner to avoid having to file a personal bankruptcy. In order to separate the two, the owner must incorporate. The most common type of small business incorporation is the limited liability company (LLC), but a small business can also be formed as a C corp or an S corp. 

Can bankruptcy help my small business? 

If it is determined that your business is in fact a separate entity from your person, you will have three bankruptcy options--Chapter 11, the new Subchapter 5, and Chapter 7. Chapter 13 is not an option. In all bankruptcy cases, the moment the bankruptcy petition is filed, you will be protected by the automatic stay. This prevents creditors from continuing debt collection efforts, including wage garnishment. 

If you file Chapter 7, you must decide whether to file for yourself personally, or for the business entity, or  both. Although filing for the business can protect your personal assets, these assets could be at risk if you made personal guarantees on any business debts. 

If, however, you plan to continue running your business post-bankruptcy, Chapter 7 is off the table. Chapter 11 and Subchapter 5 are your only options for a business bankruptcy filing in this situation. As discussed earlier, if the small business is a sole proprietorship, the only options are Chapter 7 and Chapter 13. The sole proprietor also has the option of filing both types of bankruptcy back to back, a process known as Chapter 20. 

Chapter 11 bankruptcy is similar to Chapter 13 in that it involves the reorganization of debts through a repayment plan approved by the bankruptcy court. Chapter 11 involves more fees than other types of bankruptcy, so the overall process can be prohibitively expensive. Furthermore, a business owner who files Chapter 11 will be subjected to the dreaded creditor committee, which is a group of individuals who represent the business’s creditors. 

The creditor committee is involved in creating the debtor’s reorganization plan, as well as in the decision about whether or not to liquidate. Creditor committees include both secured and unsecured creditors and can be owed large or small sums of money. However, secured creditors are generally paid back first, and unsecured creditors are typically paid in order priority. 

Another option for small business owners is the new Subchapter 5 bankruptcy, which just went into effect on Feb. 19, 2020. Subchapter 5 is essentially an easier and more compact version of Chapter 11. It was enacted to simplify the bankruptcy process for small business owners with the hope that a more cost-efficient and expeditious bankruptcy would allow more businesses to continue operating. One of the primary distinctions between Chapter 11 and Subchapter 5 is the absence of a creditor committee. This is a significant difference because the creditor committee can be the main obstacle to having a bankruptcy reorganization plan approved. In fact, a single creditor can make the entire plan go awry. 

Deciding whether or not to file bankruptcy for your business is a very personal decision. Consult with an experienced bankruptcy lawyer or visit Upsolve to learn more about your rights and options today. 

Conclusion

The type of bankruptcy you file will depend largely on whether you want to quickly and transparently close your struggling business, or reduce monthly payments and keep it afloat. Each chapter offers a different path to debt relief, with its own set of advantages and disadvantages. 

There is no shame in filing bankruptcy; for many individuals and small business owners, it is the most direct path to a fresh start. In fact, during this current economic crisis, bankruptcies filed by small business owners are projected to skyrocket to unprecedented numbers. 

But deciding to file bankruptcy is a major decision that should not be made without first doing a bit of research. The best way to ensure that you are making the right decision for your unique situation is to consult with a bankruptcy lawyer who is experienced in small business bankruptcy. 

For individuals and small business owners who are concerned about the cost of legal counsel, Upsolve offers a wealth of information and educational tools entirely for free. Through our site, you can learn about the many bankruptcy options available to you, their advantages and disadvantages, and whether or not you qualify. In fact, if you determine that Chapter 7 is the best bankruptcy solution for your unique needs, Upsolve offers a free web app for filing Chapter 7 on your own, at zero cost to you. 

Even if you choose to work with a bankruptcy attorney, it is in your best interest to do as much research on your own as possible. The better prepared you are for your initial consultation, the more time and money you will save, and the sooner you will be able to start rebuilding your financial future. Learn about different debt relief solutions and what path might be best for you by visiting Upsolve today.