Business Bankruptcy: Is It Right for Your Small Business?

December 7, 2019
Posted in: Uncategorized

 

Filing bankruptcy is the last thing a business owner wants to do. Unfortunately, whether you own a small business or are the CEO of a large corporation, you’re not immune from bankruptcy. The word “bankruptcy” generally has negative connotations but sometimes it’s a struggling business’s last resort and can often make the difference between a business staying afloat or closing its doors for good. 

In this article, we’ll discuss the most common chapters that business bankruptcies are filed under, the impact of each, how the bankruptcy process works, how bankruptcy affects credit, and ways to avoid bankruptcy.

 

bankruptcy

 

When Should a Business File for Bankruptcy?

 
The time to file for bankruptcy is when a business is failing to the point that the owner’s/owners’ personal assets are at risk. Whether the assets are protected from creditors depends on the legal structure of the business. In a sole proprietorship, there is a sole owner who is liable for all of the business’s obligations. Under this legal structure, the owner’s personal assets could be at risk from creditors if the business goes under. To keep from losing everything, bankruptcy can provide a remedy for the sole proprietor.

The owner(s) of a corporation or limited liability company (LLC) probably wouldn’t need to file bankruptcy because their personal assets aren’t at risk. Because these legal structures are separate entities from the owner(s), the liability falls on the business, not the owner(s). The personal assets of the owner(s) are protected from creditors if the business goes under. The owner(s) could simply walk away from the business so filing bankruptcy would be unnecessary. 

If you’ve decided that bankruptcy makes sense for your business, your first step should be consulting an attorney who specializes in small business bankruptcy filings. Filing bankruptcy is not a DIY project – it’s best left to an experienced attorney who can make the process go as smoothly as possible. 

 

What is Business Bankruptcy?

 
If you’re struggling to repay business debt, filing bankruptcy can help by discharging the debt or facilitating a plan to repay the debt. The remedy that bankruptcy can offer you, as a small business owner, depends on your business’s debt levels, financial situation, and ultimately the chapter of the U.S. Bankruptcy Code your case is filed under.  

There are six different chapters that bankruptcies can be filed under – each with different requirements and different goals. 

  • Chapter 7 – Businesses may file under Chapter 7 to liquidate. Individuals may file Chapter 7 or Chapter 13, depending on the specifics of their situation.
  • Chapter 9 – Municipalities: cities, towns, villages, taxing districts, municipal utilities, and school districts may file under Chapter 9 to reorganize.
  • Chapter 11 – Businesses may file under Chapter 11 to reorganize.
  • Chapter 12 – Provides debt relief to family farmers and fishermen.
  • Chapter 13 – Individuals may file either Chapter 7 or Chapter 13, depending on the specifics of their situation.
  • Chapter 15 – Bankruptcy filings that involve parties from more than one country are filed under Chapter 15.

All bankruptcy cases are handled in federal courts and the rules of procedure that govern how bankruptcy courts operate are called the Federal Rules of Bankruptcy Procedure. A bankruptcy case normally begins when the debtor files a petition with the bankruptcy court. 

 

 
The bankruptcy type, or chapter, that a business can file depends in part on the legal structure of the business. A sole proprietorship is a business owned by an individual and the business is considered to be an extension of the individual. Therefore, a sole proprietorship can’t file a bankruptcy case apart from the owner. Any bankruptcy filed must include both the owner’s personal and business debts and assets. A sole proprietor can file Chapter 7, Chapter 11, or Chapter 13, all of which are designated for individuals.

Like sole proprietors, partners are personally responsible for business debt. A partnership may file under Chapter 7 or Chapter 11, but it won’t be afforded the same benefits in Chapter 7 as a sole proprietorship.

Although Chapter 13 is only available to individuals and sole proprietors, a partnership or corporation can get similar benefits in Chapter 11 bankruptcy. Chapter 11 allows corporations to reorganize and pay less money each month to creditors. Unfortunately, many small business owners find Chapter 11 cost prohibitive because of the additional rights given to creditors and the resulting increase in legal fees.

While a corporation’s shareholders are protected from individual liability, once a corporation files Chapter 11 in federal court, it’s easy for creditors to initiate alter ego litigation which is a lawsuit that asks a court to make the shareholders pay money owed to creditors since the bankruptcy case is already there.   

 

 

Bankruptcy Chapters Commonly Filed by Businesses

 
The process of filing for bankruptcy and the results vary depending on the chapter under which the bankruptcy case is filed. Business owners can file for Chapter 7, Chapter 11, or Chapter 13 bankruptcy, depending on their financial situation and on the type of company they have. As a business owner, it’s essential that you carefully consider which chapter you should file under, the pros and cons, and the cost and effort involved. 
 

Chapter 7 Bankruptcy

 
Chapter 7 bankruptcy is the most common type of bankruptcy, making up about 62% of all business filings in 2018. It’s also called straight bankruptcy or liquidation bankruptcy. Chapter 7 is decidedly the most available and least expensive bankruptcy chapter. From start to finish, it typically takes less time to process. 

Chapter 7 bankruptcy is available to consumers and all types of businesses. This is an option if you don’t have the means to repay your business’s current debts. The result of a Chapter 7 business bankruptcy filing is liquidation of the business’s assets (with proceeds divided among creditors) and closure of the business.

Once a business files for Chapter 7, it completely shuts down operations. The officers, directors, and employees are all dismissed, and the bankruptcy court appoints a trustee to take over and liquidate the business’s assets for the benefit of creditors. Only in very rare cases does a trustee allow a business to temporarily operate during Chapter 7 proceedings. 

However, whether the business activity of a sole proprietor ceases entirely under Chapter 7 depends on the type of business. Most retail and manufacturing businesses will shut down operations. Sole proprietors who operate under their own names, like consultants, writers, or lawyers, won’t be required to stop providing their services. 

Whereas individual consumers have to meet income guidelines to qualify for discharge of debt, filers who seek to discharge business debts aren’t held to the same income requirements. If there are multiple creditors that you haven’t been able to repay, the trustee will divide up your assets among those creditors. Bankruptcy exemption laws determine if you can keep your house, automobile, pension and retirement funds, personal belongings, etc. If any of these assets are exempt, you can keep them during and after bankruptcy. If the assets are nonexempt, the trustee is entitled to sell them to pay your unsecured creditors.

If you own property worth a certain amount and the equity in that property is equal to or less than the exemption amount available in your state, you get to keep the property under Chapter 7. For example, if you own a car free and clear that’s worth $5,000 and your state has an automobile exemption of up to $8,000, you will get to keep your car because the exemption will fully protect the equity. On the other hand, if your car was worth $12,000, the bankruptcy trustee would likely sell your car, pay you $8,000 for the exemption, and pay the rest ($4,000) to your unsecured creditors. The state exemption rule you use will depend on where you lived for the past two years. If allowed in your state, you may be able to use the federal exemption rule. 

The homestead exemption applies to any real property that you use as your primary residence and that you acquired more than 40 months before filing for Chapter 7. If you acquired the property less than 40 months before filing, the homestead exemption is capped at $170,350 if you file on or after April 1, 2019 (the exemption cap changes every three years). The cap doesn’t apply if your home was purchased with the proceeds from the sale of another home in the same state.

Although all legal business structures are eligible to file Chapter 7, it’s mostly filed by sole proprietors. Once assets are liquidated, creditors are paid, and the trustee receives his/her fee, sole proprietors receive a discharge which means they are no longer responsible for repaying business debt, even if they signed a personal guarantee. A personal guarantee is a legal promise by a business owner or owners that they will personally repay any business debt should the business fail to do so. 

Partnerships, corporations, and LLCs can’t receive formal discharges of debt under Chapter 7, nor can they have their personal assets protected by bankruptcy exemption. A Chapter 7 filed by any of these legal structures is expected to result in total liquidation – the goal is to liquidate assets and pay as many creditors as possible. 

 

counting money

 

Chapter 11 Bankruptcy

 
When people hear the term “business bankruptcy”, Chapter 11 is often what comes to mind. When a business files Chapter 11 bankruptcy, they’re able to continue operating while reorganizing debts. This is an option for businesses that aren’t completely insolvent and have the potential to bounce back with help from the bankruptcy court. Chapter 11 is quite labor-intensive and thus a very expensive process considering professional fees (i.e. attorneys, accountants, etc.). 

In a Chapter 11 bankruptcy, the debtor’s management maintains control and has the ability to make decisions for the business with the approval of the court but it’s not required to obtain court approval for every detail of the daily operations. The debtor is required, however, to obtain court approval for irregular activities such as purchasing and selling real property and other assets (if that’s not the debtor’s ordinary business), major personnel changes, and entering into financing agreements. 

The debtor is called a debtor-in-possession (of its own property) and acts as its own trustee. However, if warranted, a creditor or the U.S. Trustee can request that a trustee be appointed.  The U.S. Trustee is the component of the Department of Justice that provides oversight for the administration of bankruptcy cases and private trustees. 

In most Chapter 11 cases, the court will also form a creditors’ committee comprised of creditors selected from the debtor’s 20 largest unsecured creditors. The committee is responsible for overseeing the case and representing the interests of all unsecured creditors. Any expenses incurred by creditors who serve on the committee and their approved professionals (attorneys, examiners) are the responsibility of the debtor and considered an administrative expense. 

When a business files Chapter 11 to reorganize, it will continue operations after bankruptcy proceedings as opposed to being liquidated. The business ultimately uses the bankruptcy process to cancel debt, liquidate non-performing assets, restructure long-term debt, and possibly acquire new equity or funding sources. Under its own power or with the help of a trustee, a business may also file Chapter 11 as a means for liquidation.

To be eligible to file Chapter 11, a business must be earning revenue on a regular basis. If you decide to file Chapter 11, a reorganization plan must be submitted to the court. The plan should include how and when you expect to repay all of your creditors. Before the reorganization plan can go into effect, your creditors and the court must review and approve it. 

Under Chapter 11, creditors are divided into classes – each class having similar attributes. For example, all vehicle lenders might be in one class. All bondholders could be in another class. All secured creditors could be in yet another class. Some creditors might not share attributes with any other class thereby warranting placement in a class by themselves. 

The goal of a Chapter 11 bankruptcy is to facilitate negotiation with a business’s creditors. For example, instead of having to repay debt within three years, the bankruptcy court might allow the debt to be repaid over the next 10 years. Chapter 11 aims to ensure that your business can continue operating while you regain profitability over the newly negotiated repayment period. 

 

accounting

 

Chapter 13 Bankruptcy 

 
Chapter 13 bankruptcy is an option that’s primarily for individuals, but sole proprietors can file under it as well. Corporations and partnerships can’t file under Chapter 13, although the partners who are individuals can file independent of the partnership. Chapter 13 bankruptcy is very similar to Chapter 11 but is only applicable to small businesses with a few creditors. It offers a simpler, much less expensive reorganization for small businesses than Chapter 11. 

To be eligible for Chapter 13 bankruptcy, you can’t have more than $394,725 in unsecured loans or $1,184,200 in secured loans. These limits change periodically to reflect changes in inflation and the cost of living. 

Under Chapter 13, sole proprietors can file for personal bankruptcy to reorganize their debts. As a sole proprietor, you have to file for bankruptcy under your own name, not the business’s name. Both personal and business debts are within the trustee’s scope of authority. The trustee will also consider both personal and business property to be available to pay back all debts, business or personal. 

Your business can continue operating under Chapter 13 bankruptcy. As with Chapter 11, a reorganization plan which includes how and when you expect to repay all of your creditors must be submitted to the court for approval. 

You’ll either have to repay some or all of your outstanding debt (some may be discharged) depending on your income, personal and business expenses, and the types of debt you have. Since you only get three to five years to repay debt under Chapter 13, this bankruptcy option is best for businesses with a small amount of debt. Chapter 11 is a better option for businesses with larger debt loads. 

 

How the Bankruptcy Process Works

 
If you’ve weighed all of your options (including the pros and cons of the different bankruptcy chapters), and have decided to proceed, starting the bankruptcy process is relatively simple. Sole proprietors can initiate the process on their own by filing the appropriate form and paying the filing fee. Partnerships, corporations, and LLCs must have an attorney file for them. Sole proprietors should still hire an attorney because the bankruptcy process can be challenging for a novice. 

The U.S. Bankruptcy Court oversees bankruptcy proceedings and a filer can start the process by filing an official petition in one of the court’s 94 jurisdictions.The filer’s principal business location determines the jurisdiction to file in. Once the petition is filed, there is a “stay” granted, during which creditors aren’t allowed to try to collect from you. They must wait for the bankruptcy proceeding to commence. 

Once the case is officially open for review, there are very detailed disclosures and forms that businesses must file with the court. The forms vary depending on the type of bankruptcy and the business’s legal structure. In the case of Chapter 11 and Chapter 13 reorganization bankruptcies, the management of the debtor company will be required to formally disclose its reorganization/repayment plan and seek court approval before engaging in activities that aren’t part of its regular operations.  Disclosure of the business’s assets and debts is also required as part of the reorganization plan.

Before it can take effect, the reorganization plan must be reviewed and approved by creditors. Next, a confirmation hearing takes place during which the reorganization plan is discussed.  The court will then confirm or reject the plan. If the plan is confirmed, you can continue operating your business which will allow you to earn revenue to repay your creditors. From time to time, you’ll most likely have to submit updated financials to the court to confirm that you’re in compliance with the reorganization plan. 

Once you file for bankruptcy, the filing is a matter of public record which means creditors, prospective funding sources, and others can access this information. How Long Does the Bankruptcy Process Take?

From start to finish, the bankruptcy process can be lengthy and expensive. Before even getting to the repayment part of bankruptcy proceedings, fees paid to attorneys and other professionals can be significant. A Chapter 7 bankruptcy usually takes four to six months for debts to be completely discharged. The time frame for a Chapter 13 bankruptcy to be processed is similar to that of a Chapter 7, although filers of a Chapter 13 have three to five years to repay the debt. 

A Chapter 11 bankruptcy is the lengthiest of the three business bankruptcy types. Because the reorganization plan needs to be reviewed and approved by creditors and the court, and because creditors are allowed to question the debtor in court, the process can drag on. The entire process can take up to a year, during which legal fees can pile up. 

 

piggy bank

 

How is Credit Affected After Bankruptcy?

 
When contemplating bankruptcy as a solution to crippling debt, most business owners worry about how their credit will be affected. This is a legitimate concern because when business owners file for bankruptcy, not only can their personal credit ratings be affected, but their business ratings and ability to access funding can be affected as well. 
 

Bankruptcy’s Impact on Credit

 
The way in which bankruptcy can affect your credit depends on the legal structure you operate under. If you’re a sole proprietor, there’s no legal separation between you and your business. You’re considered one and the same and as such, you’re personally responsible for all personal and business debts. If you file Chapter 7 bankruptcy, the court can discharge your debts which means you don’t have to repay them but you’ll suffer a significant blow to your credit report. The bankruptcy will show on your credit report for seven to ten years and can cause a good credit score to drop by 200+ points. A less than stellar credit score will drop by 130+ points. 

If you operate a corporation or LLC, you’re legally separated from the business. You’re not personally responsible for the debts of your business so neither the unpaid business debts nor the business bankruptcy will show on your personal credit report. It will, however, show on your business credit report where funding sources, the SBA, and suppliers are able to see it and determine if they want to do business with you.

If you signed a personal guarantee as the owner of a corporation or LLC, you’re then personally responsible for business debts, regardless of your business’s legal structure. For example, if you own an LLC, signing a personal guarantee makes you personally responsible for the LLC’s debts. The LLC’s creditors can come after your personal assets to satisfy the business debt, even if your business has filed for bankruptcy. The unpaid debt will show on your personal credit report.
 

Bankruptcy’s Impact on Future Financing

 
A bankruptcy on your credit report will undoubtedly give lenders pause. They’ll be concerned about whether you’ll honor your agreement to repay the loan with interest and on time.  Especially in the case of a Chapter 7 bankruptcy where your previous debt was discharged; a prospective lender will wonder if they’ll get paid at all. You may have to wait for three to seven years after a completed bankruptcy before most lenders will consider you for a business loan or any other type of business financing.

While you wait for the three to seven year time frame to lapse, there are other financing options available to you. Some alternative lenders will work with you just one year after a completed bankruptcy. You can also apply for a business credit card which can help build up your business and personal credit. Loans secured by collateral, such as equipment loans, is another option, even if you have a recent bankruptcy. 

Although bankruptcy will make future borrowing difficult, it won’t completely close the door on business financing. There are options available while you work to improve your credit profile so that you’ll have more funding options in the future.  

 

meeting

 

How to Avoid Business Bankruptcy

 
Before discussing how to avoid business bankruptcy, it’s necessary to first understand why most businesses go bankrupt.  
 

Reasons Why Businesses File for Bankruptcy

 

  • Market conditions Unfavorable conditions in the economy and the market in which a business operates is a common cause of business bankruptcy. Businesses involved in specific niche markets can also be susceptible to shifts in consumer preferences. For example, Blockbuster Video was forced to file bankruptcy when services like Netflix and Redbox came on the scene. Competition from behemoth companies like Amazon is another market factor that can lead to bankruptcy for smaller businesses. 
  • Too much debt Many business owners take out loans to finance their business activities. If the business later struggles, lenders may not be willing to provide additional loans which could lead to bankruptcy. Even if more financing is secured to stay afloat in the short term, the interest that has to be paid on the loans would make it more difficult for a business to be profitable.
  • Lack of planning Without adequate planning, a business owner can make hasty and unsound decisions like bringing a product to market without conducting thorough market research to see if there are enough potential customers for the product.
  • Other factors There is a host of other factors that can force a business into bankruptcy including poor business location, illness, and loss of key employees. Lawsuits filed against the business by competitors, employees, or customers can place an insurmountable financial burden on a business.

 

Ways to Avoid Bankruptcy

 

    • Eliminate non-essential expenses – Expenses that don’t add value to the business like employee lunches, gym memberships, and other perks should be eliminated. Consider teleconferencing more with free online tools like Skype to reduce travel expenses. Consider using Voice over Internet Protocol (VoIP) instead of a more expensive traditional phone plan. Obtain additional quotes for all services not under contract.
    • Sell idle assets – If you have any equipment that hasn’t been used in years, sell it and use the proceeds to pay outstanding debt. 
    • Renegotiate contracts, leases, and loans – Ask suppliers and lenders for lower monthly payments. Let them know you’re considering bankruptcy but would like to avoid it. They may be more willing to work with you once they consider that the debt to them could be discharged in bankruptcy.
    • Buy inventory on consignment Ask suppliers to consider providing inventory on a consignment or drop-ship basis. In this arrangement, you wouldn’t pay for inventory until it was sold. This would improve cash flow and reduce your level of risk in the transaction.
    • Reduce labor costs – Consider purchasing software programs to automate functions once performed by staff members. Also consider hiring staff on a temporary, freelance, or part-time basis to reduce benefit costs.
    • Monitor invoice age Create a system for staying on top of aging invoices. Develop a strategy for reducing accounts receivable to improve cash flow.
    • Delay payables Ask creditors for longer payment terms to improve cash flow. 
    • Hire a turnaround specialist Turnaround specialists generally act as either interim managers or consultants. They often replace the business owner or CEO, take the reins of a troubled business, and guide it through its current woes. They often shed additional light on a business’s problem areas. 

 

Final Thoughts

 
Filing for business bankruptcy should be a last resort. If you’ve tried everything and still aren’t able to meet your obligations to creditors or they’re bringing judgments against you, bankruptcy may be the only remedy for your ailing business. Because a bankruptcy filing has long-term financial and legal ramifications (stays on your credit report for seven to ten years and affects future financing), seek the advice of an experienced attorney before filing. 

 

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