How Your Business Structure Affects Your Bankruptcy Filing Options

Feb 25, 2021 | Bankruptcy

When the pandemic hit in the spring of 2020, it significantly rewrote national markets and the economy. Our lives changed seemingly overnight—and many businesses suffered because of it.

Bankruptcy can be an intelligent and strategic solution. And contrary to popular opinion, it isn’t the end of the road: many business owners who declare bankruptcy go on to open other, successful businesses. But it’s important to understand how your business structure affects your bankruptcy filing options. 

Sole proprietorships and bankruptcy

If you’re the sole proprietor of your business, then your personal finances and the business’s finances are legally considered the same thing. (Married couples can be sole proprietors, too.) 

This means you haven’t officially separated yourself from the business by forming a corporation, such as a Limited Liability Corporation (LLC). So when you go to file for bankruptcy, you need to file for personal bankruptcy—and there are several options available to you.

Chapter 7

If you file for bankruptcy under Chapter 7 as a sole proprietor, state law will determine how much of your property—such as home equity, a car, etc.—you’ll be allowed to keep. The rest will go to pay off your business’s debts. 

The process is managed by a legal official, called a trustee, who makes decisions in accordance with the U.S. Bankruptcy Code. Once the trustee has sorted through your estate and determined how to proceed, any remaining debt will be effectively wiped out.

Chapter 11 or 13

Although Chapters 11 and 13 operate similarly for sole proprietors, Chapter 13 is far less costly. It provides an option for business owners who can repay debts—just not at the current rate. 

Chapter 13 commits you to paying off debts through a payment plan that runs for the next three to five years. It allows you to keep running your business, but a trustee must approve every financial transaction.

Partnerships and bankruptcy

Partnerships face the greatest hurdles when it comes to filing for bankruptcy. This holds true whether you have a general partnership, a limited partnership, or a limited liability partnership.

A Chapter 7 filing doesn’t provide much protection:

  • For business partnerships, it doesn’t wipe out your debt. Instead, members of the partnership are personally responsible for the debt.
  • The business must stop operating once you file for bankruptcy.

You can also file under Chapter 11, which allows the business to keep running as a trustee manages your finances for debt repayment. But it’s often too expensive to make sense. Chapter 13 isn’t an option for partnerships.

Bankruptcy filing for LLCs and other small business corporations

An LLC or other corporation legally separates your personal finances from your business’s finances. However, many lenders require LLC business owners to be personally liable for the business’s debt, which can result in far less protection.

Liquidation

For small business corporations, a Chapter 7 filing effectively liquidates the business. The business must close and the trustee will sell off all the business’s assets to repay debts. There are no exemptions.

Then, one of two things can happen. If you aren’t personally liable for any of the debt then the process is complete, and you bear no responsibility to cover anything else that’s owed. But if you had to personally guarantee your debts, then the lender can continue to seek payment from you.

Because filing under Chapter 7 puts everything in the hands of a trustee—who’s an independent third party—it can be a good option for businesses dealing with aggressive creditors.

Reorganization

You can also file for bankruptcy under Chapter 11, which allows your business to continue running and gives you more time to pay back creditors. But the process is prohibitively expensive for many small businesses. Corporations can’t file for bankruptcy under Chapter 13.

Next steps

Whatever your business structure and financial situation, if you’re considering filing for bankruptcy, you should first talk with an attorney—preferably one who has experience in helping small businesses make strategic choices around set-up, bankruptcy, and other considerations.

And remember, bankruptcy isn’t an end or a failure—it’s a legal process that exists to give individuals and businesses a fresh start. The first step can feel hard, but once you take it, you’ll be well on your way to a bright and shiny business (and personal!) future. 

If you have questions about filing for bankruptcy, contact us. Our experienced attorneys can guide you through the process.

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