3 Types of Business Bankruptcy

Plus Info on the 2019 Small Business Reorganization Act

Business person stressed over possible bankruptcy

Most new small businesses don’t survive and are faced with the decision concerning whether they should file for some form of business bankruptcy. Between 2005 and 2017, only about one-fifth of new small businesses survived more than one year. About half of those businesses continued on for up to five years, while only about one-third made it to 10 years.

Bankruptcy is a process a business goes through in federal court. It is designed to help your business eliminate or repay its debt under the guidance and protection of the bankruptcy court. Business bankruptcies are usually described as either liquidations or reorganizations depending on the type of bankruptcy you take.

There are three types of bankruptcy that a business may file for depending on its structure. Sole proprietorships are legal extensions of the owner. The owner is responsible for all assets and liabilities of the firm. It is most common for a sole proprietorship to take bankruptcy by filing for Chapter 13, which is a reorganization bankruptcy.

Corporations and partnerships are legal business entities separate from their owners. They can file for bankruptcy protection under Chapter 7 or Chapter 11, which is a reorganization bankruptcy for businesses. The different types of bankruptcies are called “chapters” due to where they are in the U.S. Bankruptcy Code.

Chapter 13: Adjustment of Debts for Individuals With Regular Income

Chapter 13 bankruptcy is a reorganization bankruptcy typically reserved for individuals. It can be used for sole proprietorships since sole proprietorships are indistinguishable from their owners. Chapter 13 is used for small businesses when a reorganization is the goal instead of liquidation. You file a repayment plan with the bankruptcy court detailing how you are going to repay your debts. Chapter 13 and Chapter 7 bankruptcies are very different for businesses.

Chapter 13 allows the proprietorship to stay in business and repay its debts and Chapter 7 does not.

The amount you must repay depends on how much you earn, how much you owe, and how much property you own. If your personal assets are involved with your business assets, as they are if you own a sole proprietorship, you can avoid problems such as losing your house if you file Chapter 13 instead of Chapter 7. 

Chapter 7: Liquidation

Chapter 7 business bankruptcy may be the best choice when the business has no viable future. It is usually referred to as a liquidation. Chapter 7 is typically used when the debts of the business are so overwhelming that restructuring them is not feasible. Chapter 7 bankruptcy can be used for sole proprietorships, partnerships, or corporations.

Chapter 7 is also appropriate when the business does not have any substantial assets. If a business is a sole proprietorship and an extension of an owner's skills, it usually does not pay to reorganize it. and Chapter 7 becomes appropriate. Before a Chapter 7 bankruptcy is approved, the applicant is subject to a “means” test. If their income is over a certain level, their application is not approved. If a Chapter 7 bankruptcy is approved, the business is dissolved.

In Chapter 7 bankruptcy, a trustee is appointed by the bankruptcy court to take possession of the assets of the business and distribute them among the creditors. After the assets are distributed and the trustee is paid, a sole proprietor receives a "discharge" at the end of the case. A discharge means that the owner of the business is released from any obligation for the debts. Partnerships and corporations do not receive a discharge.

Chapter 11: Business Reorganization

Chapter 11 may be a better choice for businesses that may have a realistic chance to turn things around. Chapter 11 business bankruptcy is usually used for partnerships and corporations. It is also used by sole proprietorships whose income levels are too high to qualify for Chapter 13 bankruptcy.

Chapter 11 is a plan where a company reorganizes and continues in business under a court-appointed trustee. The company files a detailed plan of reorganization outlining how it will deal with its creditors. The company can terminate contracts and leases, recover assets, and repay a portion of its debts while discharging others to return to profitability. It presents the plan to its creditors will vote on the plan. If the court finds the plan is fair and equitable, it will approve the plan.

Reorganization plans provide for payments to creditors over some time. Chapter 11 bankruptcies are exceedingly complex and not all succeed. It usually takes over a year to confirm a plan. 

Small Business Reorganization Act of 2019

In August 2019, the Small Business Reorganization Act of 2019 was passed by the U.S. Congress and signed into law by the President. It enacted a new subchapter V of Chapter 11. The act is in effect as of Feb. 20, 2020. This subchapter of Chapter 11 seems to favor the side of the applicant for business bankruptcy. It only applies if the applicant wants it to apply.

For example, subchapter V does not require that a committee of creditors is appointed or that creditors have to approve a court plan.

Sole proprietorships or incorporated entities should consult with a good business bankruptcy attorney before deciding on which type of bankruptcy you will file or whether you need to file bankruptcy at all. There may be other options that can be explored.

Article Sources

  1. U.S. Small Business Administration Office of Advocacy. "Frequently Asked Questions About Small Business," Page 2. Accessed Jan. 21, 2020.

  2. U.S. Courts. "Bankruptcy." Accessed Jan 21, 2020.

  3. U.S. Courts. "Bankruptcy." Accessed Jan. 21, 2020.

  4. U.S. Courts. "Process - Bankruptcy Basics." Accessed Jan. 21, 2020.

  5. IRS. "Chapter 11 Bankruptcy - Reorganization." Accessed Jan. 21, 2020.

  6. U.S. Courts. "Highlights of Small Business Reorganization Act of 2019." Accessed Jan. 21, 2019.