A Beginner’s Guide to Business Bankruptcy
4 Options Including a New Small Business Bankruptcy Process
In tough financial times, many businesses make the difficult decision to declare bankruptcy. Federal bankruptcy laws were enacted to give individual and business debtors a “new opportunity… and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt.”
If you are considering filing business bankruptcy, you may be unsure about which type to file. Business bankruptcies come in several types, based on different “chapters” (sections) of the U.S. Bankruptcy Code. The type of bankruptcy you choose depends on your business type and your business situation (whether you want to continue your business or not).
This discussion will focus on the four main bankruptcy types available to businesses:
- Chapter 11 bankruptcy to allow businesses to continue to operate while paying creditors
- A new Chapter 11 process giving small businesses a way to file more easily and quickly
- Chapter 7 bankruptcy to give businesses and individuals a fresh start
- Chapter 13 bankruptcy for individuals with continuing income (including those who are self-employed or sole proprietors)
Common Bankruptcy Terms and Processes
Before you look at the different types of bankruptcies, here are some background terms and processes you should be aware of.
Bankruptcy process decisions are made by federal bankruptcy courts, which are found in each state and in a total of 90 districts across the country. Depending on the type of bankruptcy, the debtor may or may not need to go to court, because much of the process is administrative.
A bankruptcy trustee is a person appointed by a bankruptcy court to manage the bankruptcy process for most types of bankruptcy. However, in Chapter 11 bankruptcy, the debtor, called a “debtor in possession,” takes on the role of trustee.
You may also see the term “U.S. trustee,” which refers to the U.S. Trustee Program, a component of the Department of Justice. This program oversees the administration of bankruptcies.
Creditors are those who make claims in a bankruptcy proceeding and assert their right to be paid by the debtor. Claims are set on the date of the bankruptcy in one of two ways:
- Secured claims: Claims backed by a lien (proof of claim) on property of the debtor
- Unsecured claims: Claims not backed by property, or partly backed by the value of property
In Chapter 7 bankruptcy, secured claims are sold first to pay off secured creditors.
All bankruptcy types have specific filing and administrative fees. These include:
|Bankruptcy Type||Case Filing Fee||Administrative Fee|
In addition, bankruptcies that have trustees have a process for compensating these administrators, allowing them to take a commission or a percentage of the money repaid to creditors.
Bankruptcy Types for Specific Businesses
Sole proprietor businesses have only one owner. The business ownership is considered as part of the owner’s personal situation and it can’t be separated from the owner in bankruptcy. Sole proprietors usually file bankruptcy using Chapter 13 if they want to continue in business, or Chapter 7 if they want to start over. A sole proprietor may also select Chapter 11, and in this case, the bankruptcy filing includes both the business and personal assets of the business owner.
A partnership, limited liability company (LLC), or corporation can file Chapter 11 or Chapter 7 bankruptcy. In Chapter 11, partner assets may sometimes be used to pay creditors, or the partners may be forced to file for bankruptcy protection.
Corporations exist separately from their owners (stockholders). A Chapter 11 bankruptcy doesn’t put personal assets of stockholders at risk, but it may affect their investment in company stock.
How Bankruptcy Types Work
Chapter 11 Reorganization
Chapter 11 bankruptcy allows a business (including people in business and individuals) to keep operating while repaying creditors.
To begin the process, the debtor files a voluntary petition with the bankruptcy court, or the creditors may file an involuntary petition. Then, the debtor files financial documents and information about current creditors and assets.
A Chapter 11 debtor’s voluntary petition usually includes a reorganization plan. The debtor’s plan must list all the claims and specify how each claim will be handled. For example, some claimants may receive less than the full amount of their claim. These “impaired” claimants must vote on the plan, and the court conducts a hearing to determine whether to confirm the plan.
Instead of a trustee being appointed, the debtor becomes a “debtor in possession,” which means that the debtor keeps the business assets and controls them during the Chapter 11 reorganization process.
Since the debtor in possession is acting like a trustee, they have other powers and duties, including:
- Accounting for property
- Examining and objecting to claims
- Hiring attorneys, accountants, and other professionals to help with the process
- Filing tax returns and informational reports (i.e. monthly operating reports)
Creditors in Chapter 11 monitor the debtor in possession and participate in creating the reorganization plan.
You may be able to file a plan to sell off assets and liquidate the business in Chapter 11 under more economically advantageous circumstances than a Chapter 7 liquidation.
Chapter 11 for Small Businesses
The Small Business Reorganization Act of 2019 created a special Chapter 11 process for debtors that qualify as “small businesses.” The intent for this process is to strike a balance between Chapter 7 and Chapter 11 to allow the debtor to keep control of its assets while reorganizing. To qualify, a business must meet two tests:
- The debtor must be engaged in commercial or business activities (not including real estate) with total noncontingent liquidated secured and unsecured debts of $2,566,050 or less.
- The case must be one in which the U.S. trustee hasn’t appointed a creditor’s committee, or the committee is not active.
In addition to the two qualifications above, the debtor is subject to additional oversight by the U.S. trustee. The debtor must make ongoing filings with the court to show profits, cash receipts, and payments, and show tax payments and returns.
Chapter 7 Liquidation
Chapter 7 bankruptcy is used to liquidate personal or business assets by selling them and using the proceeds to pay off creditors. Individuals and all types of businesses can qualify to file Chapter 7. Like Chapter 11, Chapter 7 bankruptcy begins with filing a petition and providing financial and tax information.
There’s no plan of repayments in Chapter 7 bankruptcy. Instead, the trustee collects and sells the debtor’s nonexempt assets (those that are not exempt from being sold) and uses them to pay creditors. The debtor may be allowed to keep certain exempt assets.
When the petition is filed to start the bankruptcy process, it creates an automatic stay that stops most collection actions, and a case trustee is appointed. Then, the debtor must meet creditors to answer questions about their finances and property. The trustee’s role is to proceed with the liquidation of nonexempt assets.
Debts in the Chapter 7 process, which are called “discharged” debts, may or may not be collectible by creditors. Discharge of debts is only available to individuals, not to partnerships or corporations, which means a total liquidation for the latter business types.
Chapter 13 “Wage Earner” Plans
Chapter 13 bankruptcy allows for individuals who have a regular income to create a plan to repay all or part of their debts. The plan is available to individuals and to sole proprietor business owners who propose a repayment plan for repaying creditors in installments, usually over three to five years. To be eligible, the debtor must have unsecured debts of less than $394,725 and secured debts less than $1,184,200 (adjusted based on the Consumer Price Index).
After the petition is filed, the trustee holds a meeting of creditors and the debtor to resolve problems and make sure the process goes smoothly. The creditors ask questions about the debtor’s financial affairs and the repayment plan, and creditors may also come to the court for a hearing on the repayment plan. When the court confirms the plan, it’s put into place.
Chapter 13 acts like a consolidation loan, with the debtor making payments to the trustee, who then distributes payments to creditors. This keeps the debtor from direct contact with creditors.
How the Bankruptcy Process Ends
A business bankruptcy can end in different ways based on how the discharge of debts is handled. Discharge of debts is a term that describes debts that are no longer collectible by creditors. Some debts, like taxes and student loans, can’t be discharged.
The discharge process is handled differently depending on the bankruptcy type. For example, in Chapter 13, the discharge comes when the payment plan is completed. In Chapter 7, meanwhile, the court usually grants a discharge when the deadline for complaints by creditors has expired.
A bankruptcy is final when the court determines that the bankruptcy estate has been fully administered, meaning that all required tasks have been completed, including the discharge of debt. The court then releases the trustee from their duties, and a final decree is entered in the court records.
Using an Attorney for Your Bankruptcy
Partnerships, LLCs, and corporations must have an attorney to file a bankruptcy case for Chapter 11. But if you want to file bankruptcy as an individual (a process called “pro se”) without an attorney, you can do that for Chapter 7 and Chapter 13. However, the U.S. court system strongly recommends getting a qualified attorney “because bankruptcy has long-term financial and legal outcomes.”
Key Takeaways: A Quick Comparison
|Bankruptcy Type||Business Types||Attorney Needed?||Trustee?||Continue in business?|
|Chapter 11||All||Yes, for corporation, LLC, partnership||Debtor in possession||Yes|
|Chapter 11 (Small Business)||All||Yes, for corporation, LLC, partnership||Debtor in possession||Yes|
|Chapter 7||All||Yes, for corporation, LLC, partnership||Trustee||No; sell assets and close|
|Chapter 13||Individual, including self-employed or owner of unincorporated business||No||Trustee||Yes|