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Small Business Bankruptcy: The Essential Guide

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If you were to ask a group of business owners about their worst nightmare, most of them would probably say “filing for bankruptcy.” Few words in the business world carry this much dread. Many believe that having no choice but to file for business bankruptcy confirms that you’ve officially hit rock bottom. It means your business has failed, and the fact that you now have a bankruptcy on your record will change your personal and professional life forever.

However, any business bankruptcy attorney would likely agree that bankruptcy is also one of the most misunderstood terms in the business world. Contrary to popular belief, filing for business bankruptcy does not always have a purely negative outcome.

The concept of business bankruptcy was invented to help businesses deal with hazardous levels of debt. Depending on your debt’s severity, filing for bankruptcy could be the most logical solution for keeping your business alive. In some cases, filing for bankruptcy is more of a strategic move than a last resort. It might allow the company to recover without the same burdens that nearly led to its demise.

The Outcome Depends On The Type

The bankruptcy outcome also depends on the type of bankruptcy: Chapter 7, Chapter 11, or Chapter 13. Each type offers its pros and cons, so this decision must be made very carefully. Additional factors include the time and costs associated with specific processes.

In this guide, we’ll explain how small businesses file for bankruptcy, along with the risks and potential rewards of each type.

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    What is Business Bankruptcy?

    By definition, bankruptcy is the legal procedure businesses engage in when they cannot repay their debts.

    The type of bankruptcy that most people think of when they hear this word is Chapter 7. Filing for Chapter 7 bankruptcy usually results in liquidation. Business assets are distributed to creditors, so the business shuts down. This is the most common and least favorable type.

    On the other hand, Chapter 11 and Chapter 13 do not share this reputation. These two usually result in the reorganization or consolidation of the business’s debts. Plenty of companies have filed for Chapter 11 or Chapter 13 while maintaining operations and are even alive and kicking today.

    The type of bankruptcy you file for depends on your business’s debt and overall financial health.

    Why Do Businesses File for Bankruptcy?

    A myriad of circumstances can render a business unable to repay their debts. What makes bankruptcy different than other possible solutions to this problem is the opportunity to start fresh. The debts you are unable to pay are forgiven, and your creditors are given some degree of compensation.

    In other words, any debts you incurred before the filing are eliminated once the bankruptcy case comes to an end.

    Who Decides The Outcome of Bankruptcy Cases?

    Business bankruptcy cases are settled in a federal court, so the outcome is determined by an appointed bankruptcy judge. The actual legal process is administrated by a trustee, i.e., an officer appointed by the United States Trustee Program of the Department of Justice.

    What Are The Three Types of Business Bankruptcy?

    Chapter 7 is the only form of business bankruptcy that is legally available to all types of businesses. You don’t have to meet any requirements to file.

    However, chapters 11 and 13 are only available for certain types of businesses and carry specific requirements.

    Each type also has a unique legal process and can result in different outcomes for the business at hand. Here’s what happens when a business owner files for each of the three types:

    What is Chapter 7 Business Bankruptcy?

    Chapter 7 business bankruptcy is designed for businesses that cannot repay their debts because they can no longer maintain operations and earn revenue. The company shuts down so the court-appointed trustee can liquidate its assets and repay the creditors. All directors and employees are dismissed.

    The liquidation process is pretty simple. Most Chapter 7 filers owe debts to multiple creditors. Thus, the trustee divides the business’s assets to compensate each creditor for the amount owed. Thanks to federal and state bankruptcy exemption laws, creditors cannot seize certain types of personal assets. For example, you probably won’t have to give up full ownership of your home or vehicle under Chapter 7 bankruptcy.

    Though all business entities can legally file Chapter 7, most filers are reportedly sole proprietors. This is because only sole proprietors are eligible to receive what’s known as a debt “discharge” after filing Chapter 7. If you are discharged from a business debt, you will no longer be responsible for paying it back, even if the original agreement included a personal guarantee. Thus, the creditor cannot seize your personal assets.

    Discharges are not available to corporations, LLCs, and partnerships. When owners of these business entities sign a personal guarantee on a loan, filing for Chapter 7 won’t protect them from having their personal assets seized if they can’t pay off the debt.

    What is Chapter 11 Business Bankruptcy?

    Chapter 11 business bankruptcy is designed for businesses struggling with debt but not to the point where they cannot maintain operations and earn revenue. The filing allows them to negotiate new arrangements with creditors that must be approved by the bankruptcy court. For example, the bankruptcy court might approve a proposal to extend the terms of a business loan from five years to ten. The plan would have to be approved by the creditor as well.

    Thanks to these new arrangements, the business can repay its debts while maintaining operations and gradually regaining profitability.

    To file Chapter 11, your business must prove that it is currently generating steady revenue. You must also submit a reorganization plan that outlines your strategy for repaying your debts and when you expect each debt to be paid off in full. Common examples of such strategies include selling off assets, re-financing long-term debts, taking out business loans, or selling ownership shares. The bankruptcy court must approve your reorganization plan along with your creditors.

    What is Chapter 13 Business Bankruptcy?

    Chapter 13 business bankruptcy is Chapter 11 for smaller businesses. To file Chapter 13, you can’t owe more than $419,275 in unsecured loans or $1,257,850 in secured loans. For this reason, Chapter 13 is used primarily by sole proprietors since they tend to have very few creditors. Those debt limits change periodically based on factors like inflation and the average cost of living.

    If you file for Chapter 13 as a sole proprietor, you must file under your name instead of the business’s name. Sole proprietorship lacks the legal protection of registered business entities. There’s no legal difference between personal assets and business assets. The trustee will, therefore, review your personal assets when evaluating your eligibility for Chapter 13 as well as your reorganization plan.

    Earlier, we mentioned that sole proprietors are the only business entity that can have debts discharged. Hence, some sole proprietors who file for Chapter 13 only have to pay back some of their debt.

    How Do You File for Business Bankruptcy?

    Sole proprietors are the only business entity that can legally file for business bankruptcy without an attorney. Still, no business owner should file for bankruptcy on their own. The filing process is too arduous to be handled by someone simultaneously trying to run a business.

    Step one is filing an official bankruptcy petition in https://www.uscourts.gov/about-federal-courts/court-role-and-structure your business’s local jurisdiction of the US Bankruptcy Court and paying the filing fee for your type of bankruptcy. This is followed by a slew of paperwork that depends on the type of bankruptcy and your business entity.

    Chapter 7: Process

    The Chapter 7 process is underway when you receive an “automatic stay” from the bankruptcy court. This prevents creditors from pursuing the debts you owe them. The bankruptcy court is now in control of your business. You cannot continue operating or sell off any assets without the court’s approval.

    Approximately two weeks after you filed your petition, you will be asked to attend a creditors meeting with your court-appointed trustee. Though it’s not a court-held proceeding, you will have to answer why you file for bankruptcy. After the meeting, the trustee begins dividing and selling off your assets.

    Chapters 11 and 13: Process

    Once your local jurisdiction receives your official petition, you can then file your reorganization plan. In addition to your repayment strategy, your plan must include details about your business’s liabilities, assets, and current partnerships (vendors. suppliers, etc.). It’s relatively similar to the lengthy business plans required for traditional business loans.

    If your creditors approve your reorganization plan, a date for a confirmation hearing will be set. It’s here where the bankruptcy court will either accept or reject your proposed plan. If approved, you can continue running your business and put your reorganization plan into action. From the moment your plan is approved until all debts are paid off, the bankruptcy court must approve virtually all business decisions.

    You will also probably have to send financial statements to the court periodically. This will prove that you follow the strategies laid out in your plan and are on track to achieving your repayment goals.

    How Long Does it Take to File for Business Bankruptcy?

    The length of the entire bankruptcy process depends on the type. A sole proprietor who files Chapter 7 will likely be wholly discharged from their debts within four to six months. Chapter 13 is mostly filed by sole proprietors as well. For this reason, it usually doesn’t take more than six months to develop a reorganization plan and get it approved by a few creditors and the bankruptcy court. Depending on the plan’s terms, however, it could take anywhere from three to ten years for the filer to repay all of their debts.

    Chapter 11 takes significantly more time than Chapter 13 since it usually involves larger businesses with many creditors. The more creditors you have and the more money you owe, the longer it takes for creditors to approve your reorganization plan.

    During the court proceedings, creditors often question the filer about their reorganization plan and take several months to approve it. It could take well over a year for each creditor and the bankruptcy to approve the plan. This lengthy process will also result in outrageous legal fees.

    Post-Business Bankruptcy: Credit and Financing

    Regardless of the type, filing for business bankruptcy can affect your personal credit score along with your business credit score. The severity of this impact depends on your business entity. Still, there’s at least one thing that will almost certainly be much harder for any business that files for bankruptcy, and that’s obtaining business loans.

    Here’s how bankruptcy affects your credit and ability to access financing:

    How Does Business Bankruptcy Affect Credit?

    Compared to other business entities, sole proprietors will take the biggest hit to their personal credit after filing for bankruptcy. Unlike registered entities like LLCs and corporations, sole proprietors have no legal distinction between personal and business debts. After all, you can’t expect to have your debts discharged without paying some price. Sole proprietors should expect to see their scores go down by at least 120 points, and the bankruptcy will stay on their credit report for at least seven years.

    Owners of registered business entities are not personally responsible for business debts. Hence, their personal credit scores may take little if any damage from bankruptcies. The unpaid debts and bankruptcy also won’t show up on their personal credit reports. They will, however, show up on your business credit report. Individual financial institutions might review your business credit before approving financing. Vendors and suppliers will look at your business credit score before deciding to work with you as well.

    But, there is one condition in which business debts can affect registered business entities’ personal credit scores.

    You may have noticed that certain financial institutions require personal guarantees for business loans. This makes the business owner personally responsible for the debt, even if it is an LLC or corporation. So, if you file for bankruptcy after taking out a business loan with a personal guarantee, the creditor can seize your personal assets. The unpaid debt will also show up on your personal credit report. This could make it extremely difficult to obtain financing in the future.

    Can You Access Financing After Filing for Business Bankruptcy?

    Traditional institutions like banks do not forgive previous bankruptcies, even if you’ve launched a completely new business. They usually won’t approve financing until at least three to five years have passed since you repaid the debts.

    Some alternative business financing companies, on the other hand, may be willing to work with you just one year (or even less) after a bankruptcy discharge. Your chances of approval will likely be much higher if you can provide collateral.

    In summary, you should contact institutions about their bankruptcy policy before applying for financing.

    You can also build personal and business credit by obtaining business credit cards and keeping your credit utilization rate down. Yes, it’s entirely feasible to get business credit cards with a business bankruptcy on your record.

    At first, obtaining financing after filing for bankruptcy may seem nearly impossible. But believe it or not, a myriad of previously bankrupt entrepreneurs have managed to secure the means to start new businesses or reignite their current companies.

    So, while bankruptcy is undoubtedly a significant obstacle to obtaining financing, this obstacle will gradually shrink as you continue to look for options and stay disciplined with your credit.

    Business Bankruptcy: Additional Tips

    As you can see, business bankruptcy isn’t always a death sentence. But that’s no reason to take this decision lightly in any way. Business bankruptcy should only enter the discussion when you have no other possible options for repaying your debts.

    Filing for bankruptcy can negatively affect numerous aspects of your life, not just your personal credit or financing eligibility.

    For example, once you file bankruptcy forms to the court, your bankruptcy becomes public record. If you are considering filing, get ready to explain your decision to different people time and time again. It’s relatively safe to assume that anyone who should know about your bankruptcy will eventually know. This includes competing businesses, employees, family members, and potential employers.

    Depending on your desired field, having a bankruptcy on your record can make it very difficult to get a job. You should probably steer clear of the finance industry or any industry with comprehensive employee screening policies, like law enforcement. Rebuilding your reputation and sense of confidence after filing for bankruptcy could be one of the most stringent tests of your career.

    Some business owners have also made the mistake of transferring assets to different ownership before filing for bankruptcy. In their eyes, it doesn’t seem like they are doing anything wrong because the bankruptcy court has not yet taken control of the business. But once the court finds out about the transfer (and they will find out), it may seem suspicious and possibly lead to fraud charges.

    Business Bankruptcy: Leave No Doubt In Your Decision

    Earlier, we established that no business owner should file for bankruptcy without an attorney. Without the input of an expert, the decision to file for bankruptcy could seem like a no-brainer. You can’t pay your business’s debts; therefore, bankruptcy is the only option.

    But it’s not that simple. Countless businesses suffer from this problem, but bankruptcy is not the correct solution for every single one of them. Only a business bankruptcy attorney can confirm if bankruptcy will do more good than bad for your professional future. A bankruptcy could potentially stay on your credit record for upwards of ten years. Therefore, the benefits of filing must be virtually indisputable.

    When you decide to file for bankruptcy, you will change the trajectory for the rest of your life. This isn’t just another debt strategy. It’s a decision of where you want your career to be a decade from now.

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