Small businesses form a vital part of the American economy. They employ many individuals countrywide and provide all forms of services and goods, touching all kinds of industries. However, these businesses have been among the most affected by the latest economic recession due to the pandemic.

For some of these businesses, bankruptcy could be ideal if they wish to survive. In contrast, for others, it might be the only option to eliminate their overwhelming debts while closing down operations. Either option provides a way to a fresh financial start. If your small business is overwhelmed with debt and is seeking a valid way out, bankruptcy might be just what you are looking for. This blog discusses how declaring bankruptcy would work out for your small business.

Bankruptcy Options for Small Businesses

For small businesses, we have three forms of bankruptcy options to consider—Chapter 7, Chapter 11, and Chapter 13

Chapter 7 Bankruptcy

Chapter 7 bankruptcy is a type of personal bankruptcy, but businesses can benefit from it, too. It is otherwise known as liquidation bankruptcy because, under this chapter, the business must seize operations and liquidate all its assets. A bankruptcy trustee will then gather and sell all the unsecured property and pay the proceeds to the lenders to partly cover the debt before the bankruptcy court discharges the outstanding eligible debts.

If you do not have a lot of property to protect, declaring Chapter 7 bankruptcy may be the least costly and fastest way to a clean slate. It could also be ideal if the business has no future and its debts are so overwhelming that restructuring is impossible.

Your business must prevail in the means test to be eligible for bankruptcy under Chapter 7. This test considers the amount of money the business brings in compared to its expenditures. For example, if, after covering the monthly costs, a business still has funds left that can direct to repaying debts, the business is considered to have failed the means test. That means it does not qualify to declare Chapter 7 bankruptcy.

The test is in place to prevent businesses or individuals capable of repaying their debts from declaring bankruptcy just to evade debt repayment.

Chapter 11 Bankruptcy

Chapter 11 bankruptcy is a business-specific reorganization bankruptcy, unlike Chapters 7 and 13, which are also personal. It makes it less expensive and easier for small businesses to reorganize and restructure their debts and renegotiate contracts and leases. Under this chapter, the business will partly repay its debts and keep operating. If you believe in your business's long-term prospects, Chapter 11 filing is an option you want to explore. It is an ideal option if your business still makes revenue but is struggling to repay its debts.

Under this chapter, you will develop a repayment plan with your lenders and your bankruptcy trustee. Under the plan, you will make per-month payments to your lenders over multiple years. The advantage of a reorganization plan under this chapter of bankruptcy is that the business can still regain its profitability while repaying its debts. Additionally, if your lenders agree to your repayment plan, you can remain operational while repaying your business’s debts.

However, it is essential to note that debt reorganization under a Chapter 11 bankruptcy requires substantial time commitment on the business owner's part. You will be mandated to make a complete financial disclosure to creditors and the court regularly.

Chapter 11 bankruptcy can lawfully protect you from professional and personal creditors, enable you to obtain an injunction to stop foreclosure, forfeiture, or seizure proceedings, and shield future earnings and current assets. You can also work with an experienced bankruptcy attorney to discharge given IRS debts and create and maintain a budget while preventing layoffs and keeping your relationship with your vendors intact.

It is worth repeating that Chapter 11 bankruptcy is for businesses that wish to reorganize their debts instead of liquidating assets like in Chapter 7 bankruptcy.

There is the usual Chapter 11 bankruptcy, which has been on the Bankruptcy Code books for years. Then there is also Chapter 11 Subchapter V bankruptcy, which offers some small businesses a more simplified bankruptcy process. During consultations with your lawyer, they should assess whether you qualify to declare bankruptcy under Subchapter V.

A few eligibility factors exist for a Subchapter V bankruptcy. The most important one is that you do not exceed the debt limit of seven and a half million U.S. dollars of fixed debts (the outstanding amount of claims owed up to the date of bankruptcy filing).

Congress increased the Subchapter V debt limit from two and a half million U.S. dollars to seven and a half million U.S. dollars in 2020 due to the COVID-19 pandemic. This amount might be changed again later.

Chapter 13 Bankruptcy

Even though it is a kind of personal bankruptcy, Chapters 13 and 11 resemble each other as they both entail debt reorganization. In this case, you agree to develop a repayment plan based on your disposable monthly income rather than selling off business assets. The primary difference between these chapters is the types of businesses that can file.

Under this chapter, you pay your trustee a specified amount of money, which the trustee divides among your lenders. The repayment plan lasts 36 to 60 months, and once you complete it, the bankruptcy court will discharge your outstanding eligible debts.

Filing for bankruptcy under this chapter can safeguard you from IRS collections, evictions, and other lender actions while allowing you time to stabilize your business. You will still operate your business with your regular income intact and have the added advantage of making only one monthly payment to your bankruptcy trustee. Reorganization under Chapter 13 is significantly more cost-effective than the standard Chapter 11 bankruptcy.

What Kind of Business Do You Own?

Generally, the type of bankruptcy you can declare for your small business varies based on the type of legal entity it is. There are various types of small businesses. These are:

  • Sole proprietorships: if your business is a sole proprietorship, you and the business are one party. That means you are personally accountable for all the business-related debts. Lenders might be able to seize your personal property if there are insufficient funds to repay the debts. If your sole proprietorship business declares bankruptcy, they are filing for you, too.
  • Partnerships: A business partnership refers to two or several people joining as business co-owners. Business partners are jointly and severally liable for all partnership responsibilities, except if they are a limited liability partnership. A limited liability partnership protects every party from individual responsibility for the actions of their other partners.
  • LLCs (limited liability corporations) and corporations: In the cases of LLCs and corporations, the shareholder’s personal property is usually shielded from lenders. For LLCs, the personal assets of the owner are protected from lenders.

If you have a sole proprietorship, you can generally declare bankruptcy under Chapter 7 because it will be like declaring bankruptcy for yourself. You can also qualify to declare bankruptcy under Chapter 11. A business partnership can declare Chapter 11 bankruptcy if it wishes to reorganize debts and stay in business. Or, it can declare Chapter 7 bankruptcy if it plans to liquidate its assets and stop operating. LLCs and corporations can declare bankruptcy under Chapter 7 or Chapter 11.

Only sole proprietorships with debts within particular limits can declare bankruptcy under Chapter 13. This means that Chapter 13 bankruptcy is an option for sole proprietorships that are not eligible under Chapter 7 bankruptcy to reorganize their debts.

Even though Chapters 7 and 11 are an option for all types of businesses—sole proprietorships, LLCs, partnerships, and corporations—Chapter 13 bankruptcy is available only for sole proprietorships.

Since both LLCs and corporations protect the owners from individual liability, they might not even have to declare bankruptcy unless one or several of their owners personally guaranteed a loan. If personal guarantees exist, the owners who made the guarantee can file personal bankruptcy to do away with liability. Otherwise, if there is no personal guarantee, an LLC or corporation can simply shut down operations and let its lenders put the business into collection.

This leaves sole proprietorships and partnerships. For partnerships, should one partner declare bankruptcy, the business might be compelled to close down since partnership agreements usually have a clause that dissolves the partnership should one partner file for bankruptcy. The clause is meant to prevent lenders from pursuing the other remaining partners, who might have more property for collection.

If you wish to continue operating a corporation, partnership, or LLC, Chapter 11 bankruptcy would be your only option. If you have a sole proprietorship, you might have to go for Chapter 11 bankruptcy if your secured debts exceed $1,257,850 or your unsecured debts are over $419,275.

As a sole proprietor, you are personally responsible for all debts. So, you can declare any type of bankruptcy (Chapters 11, 13, and 11). However, if you declare under Chapter 13, you cannot declare under the name of your business. You must declare bankruptcy as an individual with debts in your name from your business.

Which Chapter Do You Choose?

A Chapter 7 bankruptcy filing is, in simple words, a liquidation plan. Here, the trustee will sell all the non-exempt property to repay lenders to the maximum extent possible. In California, exempt assets include a car up to a specific value, a primary home (based on its equity), tools of the trade, qualified retirement plans and pensions, household items, et cetera. Business assets will probably not be classified as exempt unless they are categorized as tools of the trade.

Filing bankruptcy under Chapter 13 is an option only for individuals and sole proprietorships with a monthly income, and it entails a repayment or reorganization plan. Here, you will generally keep all your assets, provided you continue paying for them. You must pay for your vehicle, home, and other secured items at the specified monthly rate. But if you have fallen behind on those payments, you could include the amount of the arrears in your repayment or reorganization plan, though then you will have to make the full payments every month.

Regarding unsecured debts, they will also be included in your repayment plan. Essentially, you, with your lawyer's help, will establish what your disposable income is (disposable income is the amount remaining from your per-month income after living costs) and pay it to the bank trustee monthly for three to five years, based on various factors, including income and debt level. However, note that should you lose your business and the income it generates (you do not have income), Chapter 11 or Chapter 13 will not be an option for you.

Chapter 11 bankruptcy is the same as Chapter 13 bankruptcy. However, it generally applies to businesses with debts higher than the Chapter 13 limit and those not eligible under Chapter 13 due to their business structure.

However, unlike Chapter 13, Chapter 11 enables you, as the business owner, to develop and supervise your repayment plan by yourself as a “debtor in possession.” If you are a debtor in possession, you can continue running your small business. A trustee will typically not manage your repayment plan.

Also, with Chapter 11 bankruptcy, no set time frame exists for the repayment plan as it does with Chapter 13. However, your lenders must approve your plan as part of a compulsory meeting per bankruptcy laws. Once you present the plan with your proposal, the lenders may reject it and compel you to declare Chapter 7 bankruptcy.

Whichever bankruptcy chapter you opt for, the filing process and navigating the trustee and court systems are challenging. Even deciding what chapter to file under can be a daunting task. Each chapter has its advantages and disadvantages. Chapter 7 bankruptcy can end in months, but Chapters 13 and 11 can go on for years.

Alternatives to Small Business Bankruptcy

Not all small businesses would benefit from declaring bankruptcy. In that case, there are other debt relief methods you can pursue. Your bankruptcy attorney can assist you in understanding these methods and how they may be suitable for your situation. They can also assist you in executing these methods appropriately. Also, note that one approach can work for one business and not for another, so your lawyer should suggest a technique based on your specific case and needs.

One debt relief method worth pursuing before considering bankruptcy or if bankruptcy will not work is developing a workout plan with your lenders. If your small business is sustainable, you should consider developing a restructuring plan and try negotiating with your lenders. This plan might include future projections for cash flow, historical financials, the balance sheet, and profit and loss. This information may enable you and your lenders to decide on a possible workout plan.

Negotiating about restructuring debt and a workout plan is best tasked with a professional who can remain a neutral third party to what might be disgruntled lenders. If you hire a skilled lawyer, you will have communicated to the lenders that bankruptcy filing is probable. This information might impel some lenders to consider your workout plan seriously.

Developing and presenting a restructuring plan to lenders can be lawfully time-consuming and complex if you are not conversant with it. Since the success of any workout plan is based on each lender's agreement, financial creativity, together with careful consultation, may prevent a holdout. An attorney would know how to obtain results in cases like this.

If you have explored all debt restructuring avenues and it is still necessary to liquidate your business, an alternative to declaring bankruptcy is an assignment for the benefit of lenders. The state court supervises this. This might be an excellent option if your business wants to sell off its assets, but the selling price is insufficient to pay off your debt.

Selling off your business assets via an assignment for the benefit of lenders might provide a more effective alternative to selling off the assets after declaring bankruptcy. For this process, the court selects an independent assignee who acts as a fiduciary to the lenders. The assignee then becomes responsible for asset liquidation at the maximum possible value.

Find a Competent Bankruptcy Lawyer Near Me

Should I file for bankruptcy for my small business? Under what chapter should I declare? What chapter does my business qualify for? These are essential questions you should ask yourself before declaring bankruptcy for your business. At San Diego Bankruptcy Attorney, our small business bankruptcy attorneys will analyze your case facts comprehensively.

We will assist you in making a proper decision, filing the right documentation, and responding to even your most intricate questions regarding bankruptcy for small businesses. We have legally represented countless corporations, LLCs, partnerships, and sole proprietorships and helped them navigate the bankruptcy period. Irrespective of the facts surrounding your case, we possess the experience, resources, and knowledge to help you. Call us at 619-488-6168 for a consultation and case evaluation.