10 FAQs About Bankruptcy for Small Business Owners

Bankruptcy is a scary word. However, bankruptcy laws were created to provide debtors and creditors with an orderly way to resolve debts. It is invoked when a debtor’s assets and revenue are insufficient to service its debt. Bankruptcy can be filed voluntarily by a debtor, or involuntarily by its creditors.

In either case, bankruptcy is intended as a way to provide certainty to debtors and creditors. Creditors are given an opportunity to establish the basis of their claim to payment, and debtors work out a plan to pay off debts in exchange for legal protection from collection agencies, lawsuits, and foreclosures.

Bankruptcies in the U.S. increased to 25,227 companies in the second quarter of 2016, from 24,797 companies in the first quarter of 2016. With the global pandemic and economic downturn creating dire conditions for many businesses, bankruptcy for small business owners and large corporations is becoming a looming possibility. In fact, bankruptcy filings appear to be accelerating in 2020. Thus, understanding bankruptcy for small business owners will be critically important as the economic slowdown drags on through 2020.

Here are ten FAQs about bankruptcy for small business owners:

What Is a Bankruptcy Court?

Bankruptcy is a legal process in which any individual or business can resolve their debts. While the process is legally binding on debtors and creditors, it does not take place in an ordinary court. Rather, bankruptcy proceedings are specialized proceedings that are presided over by a bankruptcy judge in bankruptcy court.

Without getting too technical, the judicial system is created by Article III of the U.S. Constitution. However, bankruptcy courts are authorized by Article I of the U.S. Constitution. This means that bankruptcy courts and bankruptcy judges are governed by different rules than ordinary federal district courts and district court judges. The biggest differences are:

  • Bankruptcy judges are appointed by a panel of circuit court judges. District court judges are nominated by the President and confirmed by the U.S. Senate.
  • Bankruptcy judges serve a term of 14 years. District court judges are appointed for life.
  • Bankruptcy judges can be fired by the circuit court judges. District court judges must be impeached by the U.S. House of Representatives and convicted by the U.S. Senate to be removed.
  • Bankruptcy courts have their jurisdiction limited to bankruptcy cases and related claims. District court judges have jurisdiction over all civil and criminal cases authorized under the U.S. Constitution.

Bankruptcy courts are governed by the Bankruptcy Code which contains the laws passed by the U.S. Congress for bankruptcy proceedings. The Federal Rules of Bankruptcy Procedure contain the court rules used by bankruptcy courts. These rules include mundane rules like the size of the paper and number of copies for filings, but also rules like time limits and deadlines for filings.

What is Reorganization?

Bankruptcy courts preside over two different forms of bankruptcy — reorganization and liquidation. Moreover, reorganization can take place under two different chapters of the Bankruptcy Code — chapter 11 and chapter 13.

The primary difference between reorganization and liquidation is that the business continues during and after a reorganization. On the other hand, a business that files for liquidation has its assets sold off and the business ceases.

Chapter 11 and 13 have different eligibility requirements. Chapter 13 is available to individuals and sole proprietorships. Chapter 11 is open to all individuals and businesses. As a result, chapter 11 reorganization is the proceeding used for bankruptcy for small business owners as well as large corporations. Because the eligibility requirements and protections vary between chapter 11 and chapter 13, you should discuss both options with lawyers before deciding which form of bankruptcy to file.

While in reorganization, debtors create a plan to restructure its debt. The reorganization plan proposes an adjustment to payment amounts and timing so that the debtor can remain in business and still pay its creditors. Under most reorganization plans creditors will wait longer to be re-paid and may only receive a fraction of the debt owed.

If the creditors are dissatisfied with the reorganization plan, they have three options:

  • File a competing plan: This option is rarely exercised.
  • Move to dismiss the bankruptcy: Dismissals are occasionally based on grounds like missed deadlines or failure to attend meetings. However, dismissals are usually filed for cause because the debtor failed to prepare or follow a reorganization plan.
  • Move to convert the bankruptcy: If the creditors do not believe the debtor can reorganize successfully, they can move to convert the chapter 11 reorganization into a chapter 7 liquidation. For example, if the debtor’s business lacks the customers to pay off the debt or the debtor’s assets are being wasted by allowing the debtor to continue its business, creditors may try to protect themselves by asking the court to shut down the debtor and sell off its assets so they can be repaid.

Reorganization is usually a good option for businesses that have good long term prospects but have hit short term problems. For example, the coronavirus pandemic and stay-at-home orders have prevented all restaurants, even if they are wildly successful, to shut down or curtail its operations. Bankruptcy for small business owners like successful restaurateurs may work out better as a reorganization than a liquidation since the restaurant will recover post-pandemic.

What is Liquidation?

Liquidation, also known as a chapter 7 bankruptcy, is a process for shutting down a business, selling off the business’s assets, and paying creditors. Generally speaking, chapter 7 is not a commonly used form of bankruptcy for small business owners who have prospects of a business recovery. If the business has reasonable prospects for recovery, a chapter 11 reorganization is a better option.

However, if the owner has decided to shut down the business, chapter 7 is the way to prevent creditors from pursuing the business and its owner for repayment. Specifically, in a chapter 7 bankruptcy, creditors are stayed from collecting debts listed in the bankruptcy petition and most of the debts listed in the bankruptcy petition are discharged at the end of the proceeding.

Some debts are not dischargeable in bankruptcy. Examples of these debts include:

  • Debts or creditors not listed on the schedules filed at the outset of the case. It does not pay to hide debts because hidden debts cannot be discharged.
  • Some federal, state, and local taxes. If your business is in financial trouble because of tax liens, chapter 7 bankruptcy will not eliminate the tax debts.
  • Government fines. Again, if the source of a business’s financial troubles is a government fine or penalty order, bankruptcy under chapter 7 will not relieve those troubles.
  • Pension plan debt. Businesses that owe money to its pension plan cannot discharge those debts through bankruptcy.
  • Debts incurred through fraud. Debtors who defraud creditors by, for example, lying on credit applications cannot receive a discharge of those debts.

During a bankruptcy for small business owners, a trustee is appointed to oversee the sale of assets. However, not all business assets can be liquidated during bankruptcy. This means that even after the bankruptcy is completed and your business’s debts are discharged, you may be entitled to keep some of your business’s assets. These might include:

  • Tools of the trade, such as tools and books. However, the value that can be exempted is limited.
  • Assets under the “wildcard” value. Debtors in some states are allowed a wildcard exemption that can be applied to any asset under a certain value (or can be partially applied to the value of any asset over the maximum value).
  • Assets “abandoned” by the trustee. If the asset is so unique or esoteric that the trustee does not believe it can be sold, the trustee will allow your business to keep it.

Can I File My Business’s Bankruptcy?

Individuals and sole proprietorships can file bankruptcy petitions without a lawyer, or pro se. However, small businesses structured as partnerships, corporation, or limited liability companies (LLCs) are prohibited under the Federal Rules of Bankruptcy Procedure from filing without a bankruptcy law attorney.

However, every bankruptcy for small business owners could proceed more smoothly with the help of a bankruptcy lawyer. Among the benefits are:

  • Avoiding procedural errors like filing the wrong forms.
  • Filing under the correct chapter based on the eligibility of your business.
  • Advising you on which debts can be discharged.
  • Protecting assets that are exempt under your state’s laws or federal law.
  • Representing and advising you during court hearings and creditor meetings.

If you hire a bankruptcy lawyer, you will likely be allowed to pay over time. Bankruptcy lawyers know that your business is in financial straits if you are filing bankruptcy and will work with you on their fees. In fact, most bankruptcy judges will want to know how you are paying your bankruptcy lawyer as part of your bankruptcy plan.

Can a Business Bankruptcy Affect Me Personally?

It can, depending on the form of your business. A sole proprietorship is treated by the law as your alter ego. This means that when your sole proprietorship files for bankruptcy, you are filing for bankruptcy as an individual. Unfortunately, nearly 70 percent of Americans have less than $1,000 stashed away and any business disruption can push a small business into bankruptcy.

If, on the other hand, your business was formed by a law firm as a limited liability entity, such as a professional corporation, limited partnership, LLC, or corporation, bankruptcy for small business is not the same as bankruptcy for small business owners. Rather, the entity declares bankruptcy and the owner(s) are spared from the effects of the bankruptcy except in very limited circumstances.

The circumstances in which a business bankruptcy can affect your personally include:

  • Personal guarantees: If you provided any personal guarantees to your business’s creditors, you will be personally responsible for any debt that is not paid during the bankruptcy. For example, if you personally guaranteed your business’s lease and your landlord only received 33% of the rent through the bankruptcy, you are responsible for the remaining 67% of the rent.
  • Partnership bankruptcies: If your business is structured as a general partnership, debts that are not discharged during the bankruptcy are divided among the general partners.
  • Non-discharged debts: Certain debts, like tax debt, will remain after the bankruptcy and can flow to the owners.

Can a Personal Bankruptcy Affect My Business?

Looking at the reverse situation, filing a personal bankruptcy can have a major impact on your business. Whether your business is a sole proprietorship, corporation, LLC, LLP, or PC, you could end up losing ownership of your business if you file for bankruptcy.

Specifically, your ownership interest or corporate shares are a personal asset. As such, it might be available to the trustee to sell to satisfy creditors. This is an important factor to consider since a personal bankruptcy might end up with a competitor buying your share of your business during your personal bankruptcy.

Some businesses are organized so that the other shareholders or owners are allowed preferential treatment in buying your ownership share in bankruptcy. For example, the partners of an insurance agency might structure the agency so any partner who declares bankruptcy can be bought out by the remaining partners. Thus, even though you might be forcibly bought out during a personal bankruptcy, your partners may be able to prevent a competitor from taking over your share and ruining your business.

What Are the Alternatives to Bankruptcy?

Bankruptcies are intended to resolve two issues:

  • Giving you a break from bill collectors to work out a repayment plan.
  • Satisfying at least part of your debt to your creditors.

Some options you might have for buying time from bill collectors could include selling business assets to catch up on bills. While used equipment might not have enormous value, a pawn shop might be willing to buy equipment easily resold like photocopiers or computers.

Another option might be to raise money by taking on investors. Specifically, any small business on the verge of bankruptcy might be unable to take on additional debt. However, you might be able to raise capital by selling part of your business to additional investors.

A round of private placement can be coordinated by broker dealers who are trained in investment banking.

How Long Will Bankruptcy Stay on My Credit Report?

A reorganization bankruptcy for small business owners will result in negative credit reports for seven years. This can seriously hamper a business’s ability to secure working capital since it may prevent the business from obtaining credit cards, revolving lines of credit, or even store credit to buy a new air conditioner from an air conditioning services provider.

A liquidation bankruptcy for small business owners will result in negative credit reports for up to ten years. However, since a business ceases operation after a liquidation, the effects of this negative reporting will be minimal or non-existent.

How Can a Business Cope With Negative Credit Reporting for Seven Years?

Businesses that have bad credit will need to look to non-traditional forms of credit. For example, hard money loans are a form of loan that does not depend on a business’s credit rating. Rather, credit is extended based on the value of collateral used to secure the loan. As such, loan values are usually capped well below the collateral value. However, it can be a way for businesses to secure funding even with bad credit.

Bankruptcy, particularly a reorganization, can help a business through temporary troubles. However, it must be approached carefully and seriously to avoid losing assets or retaining debts that could continue to endanger the business.

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