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Bankruptcy and Small Businesses: What Entrepreneurs Need to Know

A small business facing financial challenges can use bankruptcy for two purposes: liquidation or reorganization. If there is no reasonable prospect of remaining in business, a Chapter 7 liquidation can make the winding down process more orderly. If a business still has a fighting chance, a reorganization under the appropriate chapter can trim and/or restructure debt, improving the prospect of surviving and returning to financial stability.

Small businesses and Chapter 7

If you are not yet familiar with the different bankruptcy chapters, it might be helpful to read the article on that topic first. A case is filed under Chapter 7 for the purpose of liquidating the business. A business does not receive a discharge under Chapter 7, unlike an individual filing Chapter 7. A discharge gives an individual a “fresh start” after bankruptcy. Since that is not available to a business, the utility of Chapter 7 for a business is more limited.

In some cases, a business closes its doors and is not besieged by creditors. If that is the situation, a Chapter 7 may not serve any useful purpose, and dissolution of the entity under state law dissolution laws may be all that is necessary. If a business is closing, those procedures should be followed in any case, so that ongoing liabilities such as registration fees and entity taxes are not incurred.

On the other hand, the business may be facing a “feeding frenzy” by creditors with lawsuits, attachments, repossessions and other collection activities creating chaos. In that case, Chapter 7 can help. The automatic stay that takes effect on filing in all cases stops creditor collection activity. Creditors that have a lien on company assets, such as motor vehicle loans or equipment financing, have to seek permission from the bankruptcy court before they can enforce their rights against those assets.

Too little, too late – a common mistake

It may sound ironic, but it takes some money to file for bankruptcy. A Chapter 7 liquidation is not particularly expensive, but a reorganization under Chapter 13 or Chapter 11 does require some liquidity. Many times, a small business owner will wait until he is out of funds before seeking bankruptcy advice and assistance. Attorney’s fees vary widely depending on the size and complexity of the case, and attorneys won’t take these cases without retainers reasonably related to the estimated fees in the case. Aside from attorney’s fees and court fees, the business will still have an ongoing need for working capital, and falling behind on taxes or wages will cause the case to fail. It is best to seek advice as soon as there are concerns about the business meeting its obligations.

Chapter 11 and Chapter 13

It is important to understand that Chapter 13 is available only to individuals who have regular income. Thus, Chapter 13 is available for a business only if that business is a sole proprietorship. A legal entity of any type, such as a corporation, partnership, limited partnership or limited liability company, is not eligible for Chapter 13. A Chapter 13 plan is limited to 5 years in duration. If debts are very high, repaying them in 5 years may not be feasible. On the other hand, if the debtor is making his best effort to repay all that the budget allows, the rules do allow for partial repayment of the debt, the rest being discharged. Chapter 13s are overseen by the Chapter 13 Trustee.

Chapter 11 bankruptcies tend to be far more expensive than Chapter 13s, and they can be quite contentious. Creditors in most cases are allowed to file competing plans, and the plan of reorganization must be approved by a vote of the unsecured creditors. The case is also closely overseen by the United States Trustee, who can have a lot of influence over how the judge views the case. Keep in mind that the same rules apply whether the debtor is “John’s Corner Store” or a big airline, so Chapter 11 is not always realistic for a small business owner. However, there is a sub-Chapter of Chapter 11 that does provide for greater simplicity and a streamlined process if the debtor elects to be treated as a small business.


Small businesses can use the bankruptcy process to help a financially struggling business. Chapter 7 can help in structuring an orderly disposition of assets if the company is going to close. If the business is a sole proprietorship, Chapter 13 can provide an opportunity to restructure the debt over a 3 to 5 year period with a plan of reorganization. If the business is a legal entity, such as a corporation or LLC, Chapter 11 is available, although it can be costly. The error made most frequently by small businesses in financial difficulty is waiting too long to get help.

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