What Are the Types of Business Bankruptcy?
Understanding your options for dealing with business debt
on October 19, 2022
Updated on October 20, 2022
The U.S. bankruptcy code gives individuals and businesses that become unable to pay their outstanding 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 (sells) its assets to pay off its debts. When it comes to reorganizing a business in bankruptcy, “chapter 11 is what is utilized,” says California bankruptcy attorney Richard H. Golubow. Chapter 13 is also an option for some sole proprietorships.
Before filing for bankruptcy, it’s essential to be aware of your options and other debt relief strategies. You may be wondering:
- Will bankruptcy shut my business down?
- Will bankruptcy impact my personal assets?
- Will bankruptcy prevent me from starting a new business?
This article will cover the main types of business bankruptcy. Once you have the lay of the land, 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, and they wonder about the unknown—how things will ultimately be resolved. And I think they also wonder about the long-lasting effects of bankruptcy.”
For example, some long-term effects of bankruptcy include multi-year repayment plans and low credit reports.
Even though bankruptcy can be a scary prospect, Golubow says it “is recognized in the United States Constitution…as a very important constitutional right for individuals and businesses to be able to obtain a fresh start to the extent that they run into financial difficulties that result in the need to do a reset.”
“Concerning whether it’s scary, we get into the issues of the unknown,” says Golubow. “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 may arise gradually or come about suddenly.
“Many times, we’re dealing with clients where everything is going along just fine, but they’re engaged in litigation, and there’s an adverse judgment.”
After the adverse ruling, the “creditor is looking to pursue enforcement through collection activities that could not only disrupt but upend the business,” says Golubow.
“So, one reason why people sometimes need to file bankruptcy is to preserve a going-concern value for a company.” Bankruptcy can protect not only the business owner but also the “creditors of that bankrupt entity and vendors who are owed money hoping to be paid.”
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 explaining the business’s financial situation and types of debt in detail.
The petition’s purpose is to demonstrate that the business qualifies for bankruptcy.
Filing the bankruptcy petition creates an automatic stay that prevents creditors from taking legal action against you. The automatic stay gives legal protection 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).
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 (liquidated) 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:
- Chapter 7 bankruptcy
- Chapter 11 bankruptcy
- 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.
Liquidation: Chapter 7
Chapter 7 bankruptcy is often called liquidation bankruptcy and it’s the most common type of bankruptcy.
In chapter 7, the trustee working on your case sells or “liquidates” business assets in the bankruptcy estate to pay off the business’s debts.
Chapter 7 typically involves liquidating assets that businesses need to remain operational. As a result, 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.
For example, after covering its monthly expenses, a business has money left over that it could put towards paying debts. If that’s the case, the business fails the means test and cannot use chapter 7.
The means test was designed to prevent individuals or businesses with the means to pay their debts from abusing bankruptcy to avoid repayment.
Reorganization: Chapters 11 and 13
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
Suppose your business is still bringing in revenue but struggling to pay its debts. In that case, chapter 11 reorganization bankruptcy may be a good option.
Chapter 11 allows a business to remain open and operational. The debtor works with its creditors and the bankruptcy trustee to create a repayment plan.
Under a payment plan, the debtor makes monthly payments to its creditors over several years.
The benefit of a chapter 11 business reorganization plan is that the business may be able to regain profitability while eliminating its debts.
If the creditors agree to the repayment plan, the debtor can remain in business while paying off its debts.
Like Chapter 7, Chapter 11 can be used by sole proprietors, partnerships, corporations, and LLCs.
As noted above, chapter 11 is used by businesses that want to reorganize rather than liquidate under chapter 7.
“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.
When consulting with clients, Golubow assesses “whether or not [they] are eligible for filing Chapter 11 Subchapter V.”
“There are a few elements for eligibility for Subchapter V. Most important is simply that they don’t exceed the debt limitation, which is $7.5 million of fixed debt (that is, the outstanding amounts of claims that are owed as of the date that the bankruptcy petition is filed).”
Congress raised the debt limit for Subchapter V from $2.5 million to $7.5 million in 2020 in response to the Covid-19 pandemic. The amount may change in the future.
Chapter 13 Bankruptcy
Chapter 13 is very similar to chapter 11 in it 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 who don’t qualify for chapter 7 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
- 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.
As explained above, in chapter 7, the bankruptcy trustee sells company assets to repay creditors. Exemptions 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?
Suppose you are a small business owner worried about financial troubles.
Golubow’s one bit of advice is “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 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,” says Golubow.
“They wait too long, and as a result, the problems don’t resolve themselves, and more financial pressures are put on the business.”
For example, “liquidity issues arise, and then… there are fewer options available… [including] a lack of ability to obtain additional capital by way of equity or loans.”
“So, we always counsel clients to be proactive in their approach, especially since we are never recommending bankruptcy unless there is no better option,” says Golubow.
“It’s like dealing with a doctor or an insurance company,” he says. “You buy insurance hoping that there’s never a need for the insurance, but in case there is, you should be protected.”
The upshot 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, he says.
Fortunately, many attorneys provide free consultations, allowing the attorney to hear the facts of your case and for you to determine if the attorney meets your needs.
To see whether an attorney or law firm is a good fit, ask informed questions such as:
- What are your attorneys’ fees and billing options?
- What bankruptcy options does my business have?
- Can my business remain open if I file for bankruptcy?
- Will my personal assets be at risk in business bankruptcy?
- How long will a payment plan last?
- How long will my credit score be negatively impacted?
- What are the steps in the bankruptcy process?
You can visit the Super Lawyers directory and use the search box to find a lawyer based on your legal issue or location.
Look for a bankruptcy lawyer in the Super Lawyers directory.