Small Business Bankruptcy Basics

As debts pile up and customers fail to materialize, bankruptcy may be the only way out. It doesn’t have to be the end of the world, but to make the process go as smoothly and quickly as possible, business owners should know the basics of how it works.

There’s more than one way to file bankruptcy. Your particular situation will dictate which one is appropriate for your business.

Chapter 11 Bankruptcy

This is appropriate for corporations and partnerships, and occasionally for sole proprietorships. It’s the method of choice when there’s a chance the business might be able to continue going if it’s restructured. The business keeps running as it had before, but it must submit a long-term plan to the court. As the legal site, NOLO puts it, “A Chapter 11 plan is, in effect, a contract between the debtor and its creditors as to how it will operate and pay its obligations in the future.”

The owner has to run all major decisions by the court or, in some cases, a court-appointed trustee. These include decisions related to sales of assets (outside of normal business practices), shutting down or expanding aspects of the business, and entering into vendor agreements. The plan must also include a schedule for repaying the creditors.

Chapter 11 bankruptcies can take months to set up, may run for years, and don’t always succeed. The devil is in the details with these bankruptcies, and extensive professional advice is essential.

Chapter 7 Bankruptcy

Often just called a “liquidation,” this method simply winds up the business, but it’s not appropriate or even allowed for every kind of business. It’s good for sole proprietorships (even those without any assets), partnerships, or corporations. However, the court employs a “means” test to make sure high-income owners don’t use this method to easily walk away from debts they could actually pay.

Chapter 7 bankruptcy comes with a lot of caveats that can make it a poor choice for certain entities. In a sole proprietorship, there may be virtually no difference between the business and the individual who owns it. In this case, the Chapter 7 filing, in the owner’s name, can wipe out debt while allowing the business to continue.

Partnerships and corporations do not receive a discharge, however. Partners are usually advised to file for Chapter 7 in their own names to discharge both business and personal debts. Corporations are often better off selling any assets and negotiating a settlement with creditors. This also avoids what could be a devastating creditor lawsuit that may come with the Chapter 7 filing.

Because of the complexities surrounding bankruptcies, owners of struggling businesses should talk with financial and legal professionals before making a decision. Consider exploring modifying agreements with creditors outside of a bankruptcy filing, which can be in everyone’s best interests.

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