Is your small business facing bankruptcy? Or are you just looking to learn more about the different types of bankruptcy that could affect your small business?
Either way, the word “bankruptcy” can cause stress and concern about the future.
Understanding the various types of small business bankruptcies and their impact on your business is crucial.
Hi, I’m AJ! After selling my company for multiple seven figures, I created Small Business Bonfire to help aspiring and established entrepreneurs.
In the end, it’s all about making informed decisions to safeguard your business interests.
So, let’s dive into the types of small business bankruptcies and how they can affect your business.
Key Takeaways
- The most common types of bankruptcy include Chapter 7, 11, and 13.
- Chapter 11 bankruptcy is suited for large corporations and LLCs that act as separate entities from their owners.
- Chapter 7 bankruptcy is called "liquidation" because the court orders businesses to sell assets to repay creditors.
- Small business bankruptcy is when a company cannot pay its debts and must find a way to settle its obligations.
What is Small Business Bankruptcy?
Small business bankruptcy is a legal process that a small business may undergo when it can’t pay its debts.
Further, repaying debts involves the business or its creditors filing a petition with the bankruptcy court.
Then, the company has two options:
- The business can reorganize its debts and create a payment plan to pay them off.
- The company can liquidate its assets to pay off its debts.
Bankruptcy is a step most business owners don’t take lightly, but it can provide a lifeline for businesses struggling with overwhelming debt.
There are a few types of bankruptcies to consider, including the following:
- Chapter 7
- Chapter 11
- Chapter 13
Each of the bankruptcy filings differs (which I’ll cover later).
Therefore, it’s helpful to understand the bankruptcy code, so you choose what’s best for your organizational structure and situation.
How Does the Bankruptcy Process Work?
The bankruptcy process starts when a small business owner recognizes they cannot repay their company’s outstanding debts or obligations.
After that, the legal process officially begins with a debtor filing a bankruptcy petition.
Sometimes, the petition is completed on behalf of creditors, but that isn’t common.
A court-appointed trustee measures and evaluates the business assets.
The business will use the money from selling its assets to repay secured and unsecured debts.
Filing for bankruptcy serves as a fresh start for business owners.
Additionally, some forms of bankruptcy allow businesses to remain open while repaying their debt.
Types of Small Business Bankruptcies
There are three main types of bankruptcies small businesses must consider.
Depending on your company’s organizational structure, monthly earnings, and bankruptcy attorney, the type of bankruptcy that’s best for you differs.
Let’s look at how Chapter 7, 11, and 13 bankruptcy filings differ and who they’re best suited for!
Chapter 7
Chapter 7 is the most common type of bankruptcy.
Another name for Chapter 7 is liquidation bankruptcy.
Typically, Chapter 7 filings take between four and six months.
Unlike other forms of bankruptcy, federal bankruptcy laws demand business owners still pay the following types of debt:
- Alimony
- Child support
- Select taxes
- Student debt (in most cases)
- Liens on property
There are advantages and disadvantages of Chapter 7 bankruptcy (which I’ll cover later).
What is It?
As previously mentioned, Chapter 7 bankruptcy is often called ‘liquidation bankruptcy.’
If you declare bankruptcy under Chapter 7, this option typically results in your business closing during or after the process.
Therefore, businesses that cannot create a repayment plan for their debts or have no assets left to sell will declare this type of bankruptcy.
In these cases, bankruptcy laws require a trustee to sell or liquidate the company’s remaining assets in order to repay secured and unsecured debt.
Once the trustee sells everything, they distribute the money among creditors.
If there is still debt remaining, the debts are discharged, meaning the debtor is no longer legally required to pay them.
It’s important to note that although Chapter 7 can wipe out your debt, it does not erase the credit history of the bankruptcy itself, which can remain on your credit report for up to ten years.
Pros and Cons of Chapter 7 Bankruptcy
There are certain advantages and disadvantages to Chapter 7 bankruptcy.
For example, some of the pros associated with this type of bankruptcy case include:
- It relieves business owners from debt collectors
- Most Chapter 7 filers have success in getting their debts discharged
- You get to keep your property
Still, there are a few cons to know about with Chapter 7 filings, which include:
- You can’t file for Chapter 7 if your income is over a certain threshold
- The owners’ credit will take a hit
- You can lose certain types of property and nonexempt assets
Chapter 11
Chapter 11 bankruptcy is a type of reorganization bankruptcy.
Typically, large corporations and LLCs (or any business legal structure that operates separately from its owners) utilize Chapter 11.
Most small businesses don’t opt for Chapter 11 bankruptcy because it is:
- Complex
- Time-consuming
- Expensive
When a company has too much debt but still has disposable income and wants to stay in business, Chapter 11 is an excellent option.
What is It?
Chapter 11 bankruptcy allows the debtor to propose a plan of reorganization to keep its business alive and pay creditors over time.
The process begins with filing a petition in bankruptcy court, which should include the following things:
- Detailed financial information about the company’s assets
- A description of the company’s liabilities
- Business Affairs
If the court approves the bankruptcy plan, the business can decrease its debts by repaying some obligations and discharging others.
Also, the debtor can terminate burdensome contracts and leases, recover assets, and rescale operations to become profitable again.
However, during this process, the debtor remains in control of its business operations as a debtor in possession, but it is subject to the oversight and jurisdiction of the court.
Pros and Cons of Chapter 11 Bankruptcy
Like other forms of bankruptcy, Chapter 11 has its pros and cons.
For instance, some of the advantages include:
- Room for Recovery: Chapter 11 bankruptcy allows businesses to restructure their debts and continue operating, which can be a company lifesaver.
- Control of Assets: Debtors retain control of their business operations despite legal proceedings.
On the flip side, the disadvantages may include:
- Complex and Expensive: The filing process for Chapter 11 bankruptcy is notoriously difficult and costly. Legal and administrative fees can pile up, which some small businesses cannot afford.
- Public Scrutiny: During the process, the business’s financial information becomes a public record, impacting the company’s reputation and relationships with clients and suppliers.
Chapter 13
Chapter 13 is for companies with reliable disposable income who wish to keep their business but must repay their loans.
Per the bankruptcy code, businesses must follow a repayment plan that lasts between three to five years.
If the business completes the repayment plan successfully, the following types of unsecured debt are discharged:
- Personal loans
- Medical bills
- Credit card payments
This type of bankruptcy is only available for small businesses that operate under sole proprietorships.
What is It?
Chapter 13 bankruptcy, also known as a wage earner’s plan, allows individuals and businesses with regular income to develop a plan to repay all or part of their debts.
Under this bankruptcy petition, debtors propose a repayment plan to pay creditors over three to five years.
If the debtor’s current monthly income is less than the applicable state median, the plan will be for three years unless the court approves a more extended period.
Further, if the debtor’s current monthly income exceeds the applicable state median, the plan generally must be for five years.
The law forbids creditors from starting or continuing collection efforts during this period.
Pros and Cons of Chapter 13 Bankruptcy
Of course, there are advantages and disadvantages to filing for Chapter 13 bankruptcy.
For instance, some of the pros associated with this type of bankruptcy include the following:
- Control Over Assets: Chapter 13 bankruptcy allows business owners to retain control over their assets while paying their debts.
- Flexible Repayment Plan: The repayment plans are based on the debtor’s income, allowing owners to repay their debts in manageable installments.
- Potential Discharge of Remaining Debts: Some unsecured debts may be discharged after completing repayments.
Regarding the disadvantages associated with this type of bankruptcy, one must consider the following things:
- Long Commitment: The repayment plans under Chapter 13 can last up to five years, requiring a long-term financial commitment.
- Impact on Credit: Filing for Chapter 13 bankruptcy will remain on the debtor’s credit report for seven years.
- Limitations on Secured Debts: There are limits on the amounts of secured and unsecured debt a debtor can have.
Consider these pros and cons carefully before proceeding with Chapter 13 bankruptcy!
Other Types of Bankruptcies
The bankruptcy code includes other types of bankruptcies, including:
- Chapter 12
- Chapter 15
- Chapter 9
Let’s see how these bankruptcies function and who they’re best suited for!
Chapter 12: For Family Farmers and Fishermen
Chapter 12 bankruptcy is specifically designed for family farmers and fisheries.
Under this bankruptcy protection, farms and fisheries can reorganize their business while maintaining ownership.
Typically, Chapter 12 cases involve a bankruptcy trustee who helps the company devise a repayment schedule to settle their debts.
Individually and corporation-ran farms and fisheries qualify for this type of bankruptcy.
Chapter 15: For Foreign Creditors
Chapter 15 bankruptcies involve more than one country.
In 2005, the federal government created Chapter 15 bankruptcies to offer cooperation between United States courts and foreign debtors.
Chapter 15 filings intend to reduce the risk for creditors and stakeholders of foreign companies.
Put simply, Chapter 15 aims to make a bankruptcy proceeding go as smoothly as possible when it involves the United States and a foreign country.
Chapter 9: For Municipalities
Lastly, there’s Chapter 9 bankruptcy.
The government created Chapter 9 bankruptcy for financially distressed municipalities.
Further, Chapter 9 protects certain entities from creditors by developing a resolution for outstanding debts between creditors and the municipality.
Some examples of Chapter 9 entities include the following governmental entities:
- Cities/towns
- Counties
- Townships
- Municipal utilities
- Taxing districts
- School districts
Chapter 9 filings are slightly different from other bankruptcy types.
For instance, when school districts have outstanding debts, the creditor cannot force the municipality to liquidate its assets.
How to Choose Which Bankruptcy Option is Right for You?
The best way to resolve your company’s secured or unsecured debt is to consult a bankruptcy attorney.
Still, understanding the basics of bankruptcy courts helps.
For instance, Chapter 13 is only available for sole proprietorships and some partnerships.
LLCs and corporations cannot apply for Chapter 13 bankruptcy.
Further, Chapter 11 is best for larger corporations because the process is more complex.
Chapter 7 bankruptcy is suitable for any type of business.
However, Chapter 7 will most likely result in the closure of the business in question.
Closing Thoughts on the Types of Business Bankruptcy Filings
Whether your business is struggling with finances or you’re an individual in need of bankruptcy protection, understanding the different types of bankruptcy and debt relief is essential.
There are numerous bankruptcy types, but the options depend on your unique situation.
Some types of bankruptcy forgive your medical bills or child support payments!
Still, it’s always smart to consult with an attorney when you owe money to several creditors.