What is Business Bankruptcy?

A business can face such an existential threat if its liabilities exceed its assets or it runs short of cash. Both situations can be set right, but you should consider filing for bankruptcy if there is no remedy at hand. Small Business Bankruptcy puts a hold on debt collection activities and may result in some debts being canceled.

Bankruptcy used to mean insolvency, and the word is often used informally to mean just that. But, “bankruptcy” is a legal term and occurs when a court of law takes over the management of an insolvent business entity. A bankrupt business is insolvent, but a business may be insolvent and not be bankrupt.

Being in business is not for the fainthearted. Many things can go wrong. Chief among them is not enough customers, but running short on cash is a close runner up. It’s easy to think this may never happen to you. But, knowing what to do if your business faces an existential threat is much more comforting than hoping it never will.

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Types of Business Bankruptcy

There are three main types of business bankruptcy—Chapters 7, 11, and 13—each with different rules and remedies.

Chapter 13 Bankruptcy

  • Only individuals (sole proprietorships) can file
  • Automatic stay
  • Debt limits apply
  • Requires a steady stream of income
  • Significantly less costly than a Chapter 11 filing
  • Plan approval much faster than in Chapter 11

Chapter 13 bankruptcy is the legal route a small business owner could take if they wanted to continue in business despite being in dire financial straits. Chapter 13 offers a respite from creditors, and it may be possible to turn things around during this time. When you file for Chapter 13, an automatic stay immediately goes into effect. However, to be eligible for the relief Chapter 13 offers, a small business must meet certain conditions.

Chapter 13 is really only available to individuals. Therefore, only a business that has no separate legal existence from its owner, such as a sole proprietorship, can use the proceeding.

A Chapter 13 application must include a repayment plan extending over three to five years. This must be done even if the repayments are not enough to wipe out all the debts. Consequently, the business must have a steady income. But all disposable income must go into the repayment plan. Also, it cannot have more than $419,275 in unsecured debts and $1,257,850 in secured debts. If it does, it must make a Chapter 11 filing instead. If the filer’s household income is below the state’s median income, the plan will be for three years. If not, the plan is for five years.

If the payment plan is faithfully followed, at completion, any remaining balances of qualifying debts will be forgiven (discharged).

Chapter 11 Bankruptcy

  • Open to all legal business entities
  • Automatic stay
  • No income requirement
  • No debt limits
  • More costly than chapter 13 bankruptcy

A Chapter 11 bankruptcy filing is best when a business’s financial problems are temporary, and the business can overcome these financial problems if allowed some breathing space. It may also be better to keep operating the business if it is likely to be of greater value than if it were liquidated in a Chapter 7 and the assets sold off piecemeal. Additionally, the debtor—the owner of the business—is allowed to remain in control.

A Chapter 11 petition can be filed by any type of business entity, including a sole proprietorship, partnership, corporation, or limited liability company (LLC).

Chapter 11 requires more paperwork than Chapter 13 and is a great deal more costly. A trustee is not usually appointed, although creditors may ask the court to appoint one. In such cases, the trustee takes over the business’s day-to-day management to the extent they think suits the circumstances.

Small Business Reorganization Act of 2019

The Small Business Reorganization Act (SBRA), which took effect in February 2020, created a new subchapter of Chapter 11 — Subchapter V — making it easier for small businesses experiencing financial difficulty to put things right. The debtor remains in control of the business, but his actions are supervised by a trustee. The debt limit has been raised to $2,725,625, and a repayment plan can be confirmed by the court, even when creditors object.

CARES Act Makes Filing for Bankruptcy Easier

The CARES Act expands eligibility for the assistance provided by subchapter V of Chapter 11 by redefining a “small business debtor.” Until March 26, 2021, the limit has been raised from $2,725,625 to $7,500,000.

Chapter 7 Bankruptcy

  • Liquidation chapter
  • Automatic stay
  • Can be used by sole traders, partnerships, and corporations
  • No minimum or maximum debt limits

For a small business, Chapter 7 bankruptcy is appropriate when there’s no sense in keeping the business going. The chapter can be used by any type of business entity, including a sole proprietorship, partnership, corporation, or limited liability company. When you file for Chapter 7, an automatic stay immediately goes into effect.

On approval of a Chapter 7 petition, the business is dissolved. The court will then appoint a trustee who takes possession of the assets, liquidates them, and distributes the proceeds to creditors. When the asset proceeds are all distributed and the trustee is paid, a sole proprietor receives a discharge, releasing them from liability for the debt.

However, partnerships, corporations, and LLCs do not get this type of liability discharge. Although a business is dissolved on approval of the Chapter 7 filing, it still exists for purposes of winding up.

Why Would a Business File for Bankruptcy?

The main reason a business may file for bankruptcy is because its current level of revenue is not enough to pay creditors and fund operating expenses. If there’s no possibility of circumstances improving, the business could file for bankruptcy under Chapter 7. If it’s a sole proprietorship, a Chapter 7 filing offers the possibility of wiping out both personal and business debts in one go. Indeed, if the business debts are more than the personal debts, the sole proprietor won’t be subject to the “means test” like non-business individuals.

The means test is meant to ensure that individuals with adequate resources won’t be able to use Chapter 7 to wipe out their debts completely. Such individuals will have to use Chapter 13. An approved Chapter 7 petition immediately removes liability for debts. With a Chapter 13 filing, a debtor must complete the repayment plan faithfully before being absolved of any remaining balances.

Filing for bankruptcy under Chapters 7 and 13 immediately triggers an “automatic stay” that will stop any legal action creditors have started. The length of the stay varies. Typically, stays for Chapter 7 cases last three to four months, while stays for Chapter 13 cases can continue for five or more years.

How to File for Bankruptcy

The main steps for filing for bankruptcy under Chapters 13, 11, and 7 apply to all types of business entities. However, sole proprietors have to undergo a credit counseling course before filing for bankruptcy, and the certificate of completion must be submitted at the time of filing. They must also complete a debtor education course no later than 60 days after the date first set for the meeting of creditors.

Here are the phases of a bankruptcy case:

  • File petition with a bankruptcy court in the area where the business is located
  • Submit schedules of assets and liabilities, current income and expenditures, executory contracts and unexpired leases, statement of financial affairs, tax returns, and a list of creditors.
    • Additionally, for Chapter 7 cases, a schedule of "exempt" property is submitted.
  • File reorganization/repayment plan (Chapters 11 and 13) and written disclosure (Chapter 11)
  • Payment of fees
  • Issue of Automatic Stay (Chapter 7 and 13)
  • Case trustee appointed (Chaps. 7 and 13)
  • Creditors meeting (usually between 21 and 50 days after the petition is filed)
  • Approval of the disclosure statement (Chapter 11)
  • Confirmation hearings and approval of reorganization/repayment plan (Chapters 11 and 13)
  • Issue of Discharge Order

What Happens After a Business Files for Bankruptcy?

What Happens to Assets After Filing for Bankruptcy?

The fate of business assets after a bankruptcy filing depends on the type of bankruptcy. The filing of a Chapter 7 petition transfers ownership of any assets to the bankruptcy estate. This allows the trustee to sell the assets and distribute the proceeds to creditors. With a Chapter 11 or Chapter 13 case, the assets remain in the business under the control of the debtor-in-possession (i.e., the business owners).

How Bankruptcy Affects Your Business and Personal Credit

Chapter 7 bankruptcies stay on consumers’ credit reports for ten years from their filing date. Chapter 13 bankruptcies stay on consumers’ credit reports for seven years from their filing date. Paradoxically, a good credit score will take a bigger “hit” than a poorer one. A credit score of 780 or above is likely to plummet 200 to 240 points, while someone with a 680 score may just drop 130 to 150 points.

Starting a New Business After Filing for Bankruptcy

There’s nothing to stop someone who has filed for bankruptcy from starting a new business. Experience with that first failed business may have provided valuable lessons that, put into practice, make the second venture a success. Take advantage of legal ways to structure a business to ensure the business is a separate entity from its owners and that the owners are protected by “limited liability.”

Starting a similar business has to be done with care so that the entire arrangement doesn’t appear as a fraudulent maneuver to get old creditors off one’s back. Otherwise, a creditor of the old business may be able to collect from the new business by arguing it’s simply the old business in a new guise.

Recommended: Mitigate risk of bankruptcy by hiring a professional accountant to help manage and maintain the financial health of your small business.

Getting a Credit Card After Bankruptcy

Getting a new credit card after bankruptcy may not be as difficult as you think. Credit card companies have developed products for post-bankruptcy customers that are of two basic types. They offer secured credit cards, which are credit cards backed by some form of collateral, usually a deposit of cash. Unsecured credit cards are also available. Typically, they will have a low credit limit as well as a high interest rate and high fees.

How Easy Is It to Get a Loan After Filing for Bankruptcy?

It may be difficult, but it’s not impossible to get a personal or business loan post-bankruptcy. Your best bet would probably be a loan secured by some collateral so that the lender can resort to this collateral in the event that the borrower is unable to keep up with the payments.

Bankruptcy Frequently Asked Questions

What are the different types of business bankruptcies?

There are four different types of business bankruptcies: Chapter 7, Chapter 11, Chapter 12, and Chapter 13.

What is the difference between Chapter 7, 11, and 13?

Chapter 7 is a liquidation or straight bankruptcy. Chapters 11 and 13 are reorganization bankruptcies.

What is a Chapter 12 bankruptcy?

Chapter 12 is a reorganization bankruptcy for family farmers and fishers.

What type of bankruptcies exist?

There are six different types of bankruptcies: Chapter 7 for liquidation cases, Chapter 9 for municipalities, Chapter 12 for family farmers, Chapter 15 for foreign cases, and Chapter 11 and Chapter 13 for reorganization cases.

What do you lose when you file Chapter 7?

You stand to lose non-exempt assets or the value of assets that exceed certain limits.

What are the two most common types of bankruptcies?

The two most common types of bankruptcies are Chapter 7 and Chapter 13 bankruptcies.

Will I lose my business in Chapter 7?

You will likely lose your business with a Chapter 7 bankruptcy because the business assets are turned over to the case trustee. However, you may be able to exempt the business itself, any ownership interests you have in it, or its assets.

Exemptions are governed by both federal and state law with some states allowing the filer to opt for the federal exemptions. Federal exemptions include $2,525 for tools of the trade including implements and books. There is also a federal wildcard exemption that can be applied to any property which is currently $1,325 plus $12,575 of any unused portion of your homestead exemption.

Can a Chapter 7 be denied?

Yes, a Chapter 7 petition can be denied. The most likely reason for the denial is the court’s belief that the petitioner has adequate resources to pay creditors, in which case, a Chapter 13 petition should be filed.

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