Is your small business facing an overwhelming amount of debt? You’re trying your best, but there doesn’t seem to be a way out of this situation!
Don’t worry if this sounds like you; several small businesses have faced a similar situation.
Hi! My name is AJ! I started Small Business Bonfire after selling my company for a multiple seven-figure exit. Now, I aim to help entrepreneurs everywhere!
Being a business owner, I understand how challenging it is to keep a business running. Understanding Chapter 7 bankruptcy is crucial for small businesses, as it can aid in resolving financial issues.
What do I mean by Chapter 7? Keep reading to discover if filing for this type of bankruptcy is best for your situation!
What is Chapter 7 Bankruptcy for Businesses?
Chapter 7 bankruptcy is a liquidation bankruptcy.
Therefore, a trustee in a business bankruptcy Chapter 7 case sells all its property and divides the proceeds to creditors.
Typically, after a Chapter 7 bankruptcy process, the business closes.
Some companies even shut down during the process.
Chapter 7 is the quickest and most cost-effective compared to other business bankruptcy processes!
For instance, Chapter 11 bankruptcy filings are time-consuming and complex, especially compared to Chapter 7.
Still, each bankruptcy filing has its pros and cons, so it’s crucial to understand what will happen to your business, its assets, and your personal assets and liabilities after the process is complete.
How Chapter 7 Works for Businesses
In the case of Chapter 7 bankruptcy, a business declares that it’s unable to pay its debts and opts for liquidation.
When a company opts for liquidation, it involves a bankruptcy trustee (the court appoints).
The bankruptcy trustee is responsible for selling off the business assets.
Then, the company uses the funds it generates from the liquidation sale to pay off the creditors and business debts.
A bankruptcy case is a well-defined process involving the following things:
- Meticulous paperwork
- Compliance with the legal norms
- Settling business debts
Post the liquidation, the business (usually) ceases to exist. Therefore, filing for bankruptcy is a serious decision you must make carefully.
Chapter 7 Bankruptcy by Organizational Structure
How does a business bankruptcy differ by organizational structure?
For instance, the bankruptcy process is different for each of the following legal structures:
- Sole proprietor
Let’s look at these entities and how they handle business debt during a bankruptcy.
Sole Proprietor Files for Bankruptcy
Service-oriented sole proprietors can actually benefit from Chapter 7 bankruptcy; here’s how!
How Chapter 7 Works for Sole Proprietor
A sole proprietorship is owned and operated by one person.
In this case, the individual and their business are considered as one entity in terms of legal liability.
When a sole proprietor files for bankruptcy under Chapter 7, it’s the individual who goes through the process rather than the business itself.
The trustee will still sell off any assets that belong to the sole proprietorship (such as equipment or inventory).
Then, the owner uses the proceeds to pay off any business debts.
If the business’s assets don’t cover the debt the owner owes to creditors, the bank relies on personal liability to cover the charges.
Advantages of Chapter 7 for Sole Proprietors
Many people think that when a business fails and files for bankruptcy, nothing good can come from it.
However, that’s far from the truth! Chapter 7 can be beneficial in some circumstances.
For example, some advantages of Chapter 7 business bankruptcy for sole proprietors include the following:
- Owners can clear personal debts
- Under some personal obligations, you don’t need to meet the income requirements for Chapter 7
- Service-oriented businesses can survive because the bankruptcy trustee can’t take your talents away (meaning you can start another business later)
Disadvantages of Chapter 7 for Sole Proprietors
Although there are some advantages, there are some downsides to know about with this type of bankruptcy.
For instance, some cons of this type of bankruptcy include the following:
- It is a bad option if the business demands equipment or property to run their business
- Not all states protect business property the same way or at the same amount
- The company (usually) ceases to exist once the process is over
Partnership Files for Bankruptcy
Partnerships are another common business legal structure.
Let’s see how a Chapter 7 bankruptcy case can impact partnerships!
How Chapter 7 Works for Partnerships
In a partnership business, more than one person owns and manages the operations.
The partners are usually personally responsible for all debts incurred by the business.
Therefore, when a partnership files for bankruptcy under Chapter 7, each partner must file their own bankruptcy claim.
Like sole proprietors, all of a business’s assets are liquidated and divided between creditors.
These cases involve a trustee responsible for selling the company’s assets and repaying all debts.
Advantages of Chapter 7 for Partnerships
A couple of upsides of filing for business bankruptcy include the following:
- Compared to other bankruptcies, it’s a simple process
- The process is orderly
- You can use assets to sell the business’s debts
- The debts are split between two or more people instead of one person taking on all the burden
Disadvantages of Chapter 7 for Partnerships
Here are the disadvantages of Chapter 7 for partnerships:
- It increases litigation risk
- It increases the likelihood of partnership disputes
- Each partner’s personal assets are at risk
The most significant disadvantage of a Chapter 7 filing for partnerships is that it can severely impact personal relationships in the future.
Therefore, it’s helpful to go into business with someone you trust. Also, discussing what happens in the event of bankruptcy ensures no surprises!
LLC or Corporation Files for Bankruptcy
A corporation or LLC business bankruptcy differs from a personal bankruptcy because the entity is separate from its owners.
How Chapter 7 Works for LLCs & Corporations
Here’s how a Chapter 7 bankruptcy works for LLCs and corporations!
The trustee sells all of the corporation or LLC’s assets and distributes the assets based on priority rules.
Filling for Chapter 7 closes the business and doesn’t allow the entity to receive a debt exchange.
Therefore, a creditor can see payment under a personal guarantee!
Advantages of Chapter 7 for LLCs & Corporations
Some advantages of this type of business bankruptcy include the following:
- Allows for a higher level of transparency (more accessible to prove the closure happened)
- It might prevent a creditor from pursuing litigation
- Many business owners don’t have to sell their personal assets themselves; a trustee does
Disadvantages of Chapter 7 for LLCs & Corporations
Some cons to this process include the following things:
- Trustees may like the debtor’s assets for much less than what they’re worth
- A trustee takes part of the proceeds from the sale
- Owners can’t negotiate their debt for an amount lower than what they owe
Personal Liability for Corporate or LLC Debts
Although LLCs and corporations are separate entities, the owners can still be personally liable for certain business obligations.
Some situations that can cause personal liability include:
- Trust fund taxes
- Alter ego claims
- Fraud claims
- Personal guarantees
Trust Fund Taxes
Trust fund taxes are taxes withheld from an employee’s income.
Responsible parties like officers or managing members are sometimes liable for these trust fund taxes.
Alter Ego Claims
According to bankruptcy law, creditors can go after personal assets if they can prove the corporation/LLC was fake or an alter ego of the shareholder.
This type of claim involves a lawsuit against the corporation that hides the shareholder’s private assets.
Typically, businesses use fraud to hide money from creditors.
Therefore, when creditors can prove fraud, the individual must pay back all the money.
Additionally, the owner can face criminal charges for fraud claims.
A personal guarantee is when an individual agrees to pay off the business debt by taking one of the following actions:
- Cosigning a loan
- Personally guaranteeing a loan
- Pledging personal assets as collateral
The most common personal guarantee is putting valuable items up for collateral.
For instance, a business owner might put their speedboat or car up for collateral so the bank has something tangible to ensure debts are repaid.
Chapter 7 Vs. Chapter 11 Bankruptcy
Chapter 7 and Chapter 11 serve different purposes and are chosen based on the individual situation of a business.
For instance, Chapter 7 is essentially a liquidation bankruptcy.
Therefore, this type of business bankruptcy is meant for companies with no viable future.
Further, Chapter 7 is a way to turn assets into as much money as possible.
The owners then use the money to pay off the business debt.
On the other hand, Chapter 11 is a reorganization bankruptcy.
Chapter 11 is for businesses that have hit a tough spot but still have a chance of recovery.
Further, this type of bankruptcy allows the company to restructure its debts and obligations.
Essentially, it buys time for the business to bounce back and become profitable again!
Chapter 7 Vs. Chapter 13 Bankruptcy
Another type of bankruptcy is Chapter 13.
Again, Chapter 7 and Chapter 13 are two kinds of bankruptcy that serve different purposes and are suited to varying circumstances.
Chapter 7, as we’ve discussed, is essentially liquidation bankruptcy.
Chapter 7 bankruptcy suits businesses that see no feasible future and wish to cease operations, liquidate their assets, and use the proceeds to repay creditors.
However, Chapter 13 bankruptcy is a repayment or reorganization bankruptcy.
The bankruptcy court designed this type of bankruptcy for individuals with regular income who can repay a portion of their debts through a repayment plan.
Unlike Chapter 7, which wipes out business debts entirely after assets are sold, Chapter 13 allows individuals to restructure their debt payments over a period of three to five years.
Further, the Chapter 13 structure enables business owners to retain their property and assets while they work on fulfilling their repayment responsibilities.
As you can see, Chapter 13 bankruptcy is more lenient than Chapter 7, especially if the business owner still has regular income sources.
Alternatives to Chapter 7 Bankruptcy
Although a Chapter 7 bankruptcy filing is the best option for some companies, other small business owners need an alternative.
Fortunately, there are two alternatives to Chapter 7 you should consider!
Let’s see when the business chapter should use Chapter 11 or 13 bankruptcy!
Chapter 11 Bankruptcy for Small Businesses
Chapter 11 bankruptcy is a form of reorganization bankruptcy.
Typically, these types of bankruptcies are:
Because of these factors, small businesses usually don’t file for bankruptcy under Chapter 11.
Instead, larger, more organized businesses file for this type of bankruptcy.
However, Chapter 11 is beneficial for small businesses if they want to restructure and continue operating when it’s a partnership.
Also, Chapter 11 is a great option for small businesses if they owe a lot of money to secured or unsecured creditors.
In cases where companies owe lots of money, Chapter 11 is the only way to file for bankruptcy and stay in business.
How does Chapter 11 bankruptcy work?
Typically, these cases are for businesses that suddenly find themselves in a tight financial situation (due to the economy or downturns).
After a company files for bankruptcy under Chapter 11, an “automatic stay” prevents (most) unsecured and secured creditors from pursuing their money.
For example, the automatic stay temporarily stops the following things:
- Payment requests
- Collections trials
- Bank levies, till taps, and property seizures
- Other collections processes
Then, the person who filed for bankruptcy must create a payment plan through a bankruptcy court.
These payment plans can include details like:
- Modified interest
- Different payment due dates
- Erasure of debts
Consulting a bankruptcy attorney is the best way to determine whether this type of filing is best for your company and situation!
Chapter 13 Bankruptcy for Small Businesses
Another Chapter 7 bankruptcy alternative is a Chapter 13 filing.
With a Chapter 13 filing, business owners can keep their assets while reorganizing and paying off their remaining debt.
Typically, a Chapter 13 repayment plan lasts between three and five years.
When your payment plan is complete, the bankruptcy court discharges your remaining unsecured debts.
Further, this type of bankruptcy can also help you protect your assets from repossession or foreclosure by creditors.
In certain circumstances, Chapter 13 is a better option than Chapter 7 for small businesses since it lets them restructure and keep their assets.
However, it’s not ideal for every company.
For instance, sole proprietorships can’t file for bankruptcy under Chapter 13.
Also, business filings under Chapter 13 have lower debt limits than those filed for personal finances.
Similar to a Chapter 11 filing, consulting with a bankruptcy attorney is the best way to determine if this type of bankruptcy is right for your small business.
Final Thoughts on Chapter 7 Bankruptcy for Small Businesses
Chapter 7 bankruptcy can be a viable path for small businesses that have reached an insurmountable financial hurdle.
However, it’s critical to remember that this option ultimately means closing your business.
For those who see the potential for recovery, exploring alternatives such as Chapter 11 and Chapter 13 bankruptcies might be more beneficial!
What additional questions do you have about Chapter 7 bankruptcy? Let us know in the comments section below!
And if you’re pursuing a Chapter 7 bankruptcy, good luck selling assets and settling debts!