Many small business owners in Pennsylvania are struggling with debt. Bankruptcy offers several options for reorganizing or liquidating a small business that can no longer afford to pay its bills, but the type of bankruptcy and how it will unfold depends on the legal structure of the business and its available resources.
Sole Proprietor, LLC, or Corporation?
A small business owner may operate as a sole proprietor or under a separate legal structure such as a corporation or limited liability company (LLC). The critical difference here is that a sole proprietor is personally liable for any business debts. That is, there is no legal distinction between the individual and the business. In contrast, a corporation or LLC is a business entity that exists separately from the owner—even if he or she is the sole shareholder or member.
Individuals and business entities can both file for Chapter 7 bankruptcy. Chapter 7 is known as a “liquidation” bankruptcy, since a court-appointed trustee takes possession of the debtor's assets, liquidates them, and uses the proceeds to pay off creditors as much as possible. The bankruptcy court will then typically discharge the remaining debts.
In a personal Chapter 7 bankruptcy, the individual debtor is allowed to exempt a certain amount of assets from liquidation. In Pennsylvania, a debtor may choose between a list of exemptions created by the state or the one contained in the federal bankruptcy code. A qualified Pennsylvania bankruptcy attorney can advise you on which exemptions are best for your situation.
Meanwhile business entities—corporations and LLCs—cannot use any exemptions under Chapter 7. This means that a sole proprietor who files for Chapter 7 may still be able to protect some business through personal exemptions, while an LLC must liquidate everything.
Chapter 11 vs. Chapter 13
Chapter 7 works best when you want to close a business and be free of debt. If you want to keep your small business going, however, you should consider filing for bankruptcy under Chapter 11 or Chapter 13.
“In Chapter 7, a trustee is appointed and the business must stop; in Chapter 11 you have the right to control the process and try to reorganize it; and Chapter 13 is kind of a hybrid of the two, because a trustee is often appointed and doesn’t run the business, but is still in charge of its reorganization process,” summarizes Mark Freedlander
of McGuireWoods in Pittsburgh.
Chapter 13 is only available to individuals, not business entities. A sole proprietor can keep all of their assets under Chapter 13 while submitting a repayment plan to the court for dealing with any outstanding debts. In some cases a debtor must use Chapter 13 because they have too many assets to qualify for Chapter 7.
Chapter 11 is available to both individuals and business entities, though it is mostly used by the latter. Chapter 11 is expressly designed to facilitate the reorganization of active businesses. It is significantly more complicated than Chapter 13, though there are special provisions for small businesses that owe less than $2.56 million to their creditors.
Freedlander primarily handles Chapter 11 bankruptcy cases for corporations and creditors. In his experience, it’s common for a business to take on too much debt in anticipation of something occurring that never does, such as an increase in business. “But more often than not there’s a lack of foresight,” Freedlander says, “a failure to predict how the business is going to change and act in an appropriate manner. It happens time and time again.”
One advantage that a small business owner has is the flexibility to react quickly to unforeseen circumstances, but preparing for the worst is always best. “You have to be in a position where you’re ahead of the curve and have sufficient liquidity to tide the storm and sustain when things don’t go the way you expect,” Freedlander says.