What Are the Types of Business Bankruptcy?

The U.S. bankruptcy code gives people and businesses who can’t pay their debts a chance at a fresh start. The different types of bankruptcy are named after chapters of the U.S. Bankruptcy Code. 

Chapter 7 is the most common type of bankruptcy. Under Chapter 7, a business liquidates or sells its assets to pay off its debts. If you want to reorganize your debts rather than liquidate, “You use Chapter 11,” says Richard H. Golubow, a bankruptcy attorney at Winthrop Golubow Hollander in Newport Beach, California. Chapter 13 is also a debt reorganization option for some sole proprietorships.  

Before filing for bankruptcy, it’s essential to be aware of your options and other debt relief strategies. Once you’ve gotten the lay of the land with this article, speak with an experienced bankruptcy attorney about your situation.  

What Is Bankruptcy?  

Bankruptcy is a court-administered process for consumers and businesses to pay back creditors and eliminate outstanding debts. “What bankruptcy is known for is providing people and companies with a fresh start,” says Golubow. 

“Bankruptcy can be scary from the standpoint that most people have never filed bankruptcy before. They wonder about the unknown. How will things ultimately be resolved? And I think they also wonder about the long-lasting effects of bankruptcy.” 

Some long-term effects of bankruptcy include multi-year repayment plans and low credit reports. 

Bankruptcy Is a Constitutional Right

Even though bankruptcy can be a scary prospect, “It is recognized in the U.S. Constitution as a very important constitutional right. It’s a way for people and businesses to get a fresh start. To the extent they run into financial difficulties, they can do a reset,” says Golubow. “Concerning whether it’s scary, we get into issues of the unknown. Often, prospective clients show concern about how things will work out.” 

To manage this fear of the unknown, bankruptcy attorneys work with clients to “lay out a very extensive framework so that they understand the benefits that we’re looking to achieve given their facts and circumstances,” he says.   

Financial Problems Can Be Gradual or Sudden

Financial problems may arise gradually or come about suddenly. “Many times, we’re dealing with clients for whom everything was going along just fine. But they become engaged in litigation and there’s an adverse judgment,” explains Golubow.

“After the adverse ruling, the creditor is looking to pursue enforcement through collection activities that could not only disrupt but upend the business. So, one reason why people sometimes need to file bankruptcy is to preserve a going-concern value for a company.”

Bankruptcy can also protect the “creditors of the bankrupt entity and vendors who are owed money and hoping to be paid,” adds Golubow. By helping a business return to profitability, bankruptcy can allow a business and its partners to “continue to profit from an existing relationship,” he says.  

What Is Bankruptcy Court? 

A bankruptcy court is a specialized federal court that exclusively handles bankruptcy cases.  

To start bankruptcy proceedings, a business files a bankruptcy petition with the local bankruptcy court clerk. The petition is a collection of documents detailing the business’s financial situation and types of debt. The petition’s purpose is to demonstrate that the business qualifies for bankruptcy. 

Filing the bankruptcy petition creates an automatic stay, which prevents creditors from taking legal action against you while your debts are settled through bankruptcy. 

Once bankruptcy is initiated, a bankruptcy estate is created. The estate consists of all the debtor’s property. In Chapter 7, property in the bankruptcy estate is sold and used to pay off debts (more on that below).  

Role of the Bankruptcy Trustee

The person who administers the bankruptcy estate is a court-appointed official called a bankruptcy trustee. Trustees are appointed in:

• Chapter 7 cases
• Chapter 13 cases
• Chapter 11, Subchapter V cases (generally with more limited powers)
• Other types of Chapter 11 cases, though this is rare

Your creditors will be notified that you have filed for bankruptcy and there will be a meeting of the creditors during which they can ask questions about your financial situation. Often, creditors don’t show up to these meetings. However, they are still important since the debtor must appear and testify about their financial situation under oath and penalty of perjury.

Depending on the type of bankruptcy you file, your assets will ultimately be sold to pay off debts, or you will create a debt repayment plan to repay creditors over the course of a few years. 

What Are the Most Common Types of Business Bankruptcy? 

For businesses, there are three main types of bankruptcy:  

1. Chapter 7 bankruptcy 
2. Chapter 11 bankruptcy 
3. Chapter 13 bankruptcy 

The name of each type of bankruptcy comes from the section of the U.S. Bankruptcy Code where the bankruptcy is found. 

Chapter 7: Liquidation

In a Chapter 7 bankruptcy, the trustee sells or liquidates business assets to pay off the business’s debts. Since Chapter 7 typically liquidates assets that a business needs to remain operational, most businesses close after a Chapter 7 bankruptcy.  

To qualify for Chapter 7, businesses must pass the means test. In essence, the means test looks at how much money a business makes compared with its expenses. If a business has money left over after covering its monthly expenses, it could put that money toward debt repayment. Such a business would fail the means test and be ineligible to use Chapter 7. 

The means test was designed to prevent people or businesses with the means to pay their debts from abusing bankruptcy to avoid repayment. 

Chapter 7 can be used by sole proprietorships, partnerships, corporations, and limited liability companies (LLCs). 

Chapters 11 and 13: Reorganization

Two other types of business bankruptcy involve reorganizing the business’s debts and setting up a repayment plan instead of liquidating the business’s assets to pay off debts. 

Chapter 11 Bankruptcy 

If your business is still bringing in revenue but struggling to pay its debts, Chapter 11 may be a good option. 

Chapter 11 allows a business to remain open and operational. The debtor works with the creditors and bankruptcy trustee to create a repayment plan consisting of monthly payments over several years. If the creditors agree to the repayment plan, the debtor can remain in business while paying off its debts. 

“There’s the general Chapter 11 that’s been on the books of the Bankruptcy Code for decades. Then there’s also Subchapter V, which provides a simplified bankruptcy procedure for some businesses,” notes Golubow. “There are a few elements for eligibility for Subchapter V. Most important is simply that they don’t exceed the debt limitation, which is $3.02 million of fixed debt. Fixed debt is the outstanding amount in claims that are owed as of the date that the bankruptcy petition is filed.” 

Chapter 11 can be used by sole proprietors, partnerships, corporations, and LLCs.

Chapter 13 Bankruptcy 

Like Chapter 11, Chapter 13 creates a bankruptcy repayment plan instead of liquidating business assets. The main difference between Chapters 11 and 13 is who can use them.  

Chapter 13 is primarily a type of personal bankruptcy in which individuals, not businesses, reorganize their personal debts. However, Chapter 13 can also be used by sole proprietors. 

Will You Go Out of Business if You File for Bankruptcy? 

The answer to this question will depend on your business’s cash flow, financial situation, and ability to repay debts. Businesses that file for Chapter 7 often go out of business since they must sell off assets to repay creditors. Businesses that file for either Chapter 11 or Chapter 13 can remain in business while they repay creditors. 

It’s important to raise this issue with a bankruptcy attorney to understand your business’s viability during bankruptcy. 

Will You Lose Your Personal Assets if You File for Business Bankruptcy? 

This depends on the type of bankruptcy you file and your business structure.

For example, if your business is a corporation or an LLC, bankruptcy generally shouldn’t impact your personal assets unless you used personal assets to secure a loan for the business. But if your business is a sole proprietorship and you used personal assets such as your house to secure a loan, those assets may be at risk in a Chapter 7 bankruptcy.

It’s best to speak with an experienced lawyer about your situation and personal liability. 

What Are Bankruptcy Exemptions? 

In bankruptcy law, exemptions are things you can keep when you file bankruptcy.  They protect some types of property from being sold.  

There are exemptions in both federal law and state law. If a state has its own set of exemptions, you generally follow the state exemptions. You default to the federal exemption scheme if there are no state exemptions.  

When Should You Speak With a Bankruptcy Lawyer? 

Golubow’s has a piece of advice for small business owners who are worried about financial troubles. “If you’re paying attention to what’s going on with your business, there’s a very good chance you can see a problem on the horizon. And when you acknowledge that there’s a potential problem, it’s best to reach out to us. When a bankruptcy lawyer is brought in to assess a situation sooner rather than later, options and money are generally available to fix whatever problems currently exist, or problems on the horizon,” he says.

“The biggest problem we run into is that people don’t want to acknowledge that there is a problem and that they should retain professionals who are experts in this field. They wait too long. The problems don’t resolve themselves. More financial pressures are put on the business. So, we always counsel clients to be proactive in their approach, especially since we are never recommending bankruptcy unless there is no better option.”

The positive side, Golubow adds, is that “when we can meet with clients early and proactively deal with things, it’s generally less expensive, more productive, and less stressful. You ultimately want to analyze your financial difficulties when you have time to put together a comprehensive plan rather than acting out of panic when options have run out.”

Finding Experienced Legal Help

Visit the Super Lawyers directory to find an experienced bankruptcy lawyer in your area.