Business entities must generally choose between two types of bankruptcy: a Chapter 11 reorganization, which is a time-consuming and expensive process virtually only worthwhile for the largest corporations, and a Chapter 7 liquidation bankruptcy, in which business assets are liquidated and the business virtually always ceases to exist.
Chapter 13 bankruptcies are nonliquidation bankruptcies, meaning assets typically needn’t be sold off and debts are instead restructured. Business entities aren’t eligible for Chapter 13 bankruptcies. However, independent business owners can file for Chapter 13 in their personal capacity, which may be able to help their business indirectly, though business debts can’t be touched.
In contrast, both individuals and businesses can file for Chapter 7 bankruptcy. This is often the quickest and cheapest way to wind up a struggling business. Though business debts aren’t technically eliminated by Chapter 7, there’s no value left in the business by the end of the bankruptcy process; therefore, there’s nothing for creditors to collect, and the business is typically dissolved as soon as legally allowable.
But, similar to how an independent business owner might use a Chapter 13 bankruptcy, anyone wishing to preserve their small business through a rough patch might consider using a personal Chapter 7 bankruptcy instead.
A Back Door For Small-Business Bankruptcies
Let me be clear from the outset: This is not going to be the best option for everyone, and it may not even be feasible for many small-business owners. But if relieving your personal debt burden would allow you to keep more money in your business, improve its cash flow and allow it to survive until business (and profits) pick back up, a personal Chapter 7 bankruptcy may be an effective means to end.
The bad news is that you could have to liquidate some of your assets to pay as much as you can toward your personal debts in a process overseen by a court-appointed trustee. Your primary residence and retirement accounts will generally be protected from creditors, meaning you likely won’t have to sell or deplete those as part of your bankruptcy. Nonretirement savings and investment accounts that are in your name, however — that is, assets that are not owned by your separate business entity — could be at risk
Meanwhile, after the trustee distributes the proceeds of your asset sales to your creditors, your debts will be considered legally settled. You have to be careful not to reaffirm your debt by agreeing you owe money, agreeing to pay money or making any payment after bankruptcy. Otherwise, you’ll be right back where you started, but your personal debts will be cleared. That will mean reduced, if not eliminated, monthly payment obligations, which may mean pulling less income out of your business and keeping it afloat instead.
You might also be able to reorganize certain debts and assets prior to your bankruptcy to take more advantage of this route. The court will scrutinize your transactions in the period leading up to your bankruptcy, so you need to be careful here and stay well within the letter of the law. Consult your accountant and your lawyer before you make any money moves.
Another advantage of a personal Chapter 7 bankruptcy is that you and your spouse, if married, don’t both have to file. You can file for Chapter 7 bankruptcy, while your spouse’s assets and income remain unaffected. Bear in mind, this is only true of assets held solely in your spouse’s name; jointly held assets may be split to protect your spouse’s share but could all be at risk
As with the potential to shift certain liabilities and assets between business and personal domains, you might be able to shift things around between you and your spouse to take the best legal advantage of bankruptcy. And again, you’ll need to consult with an experienced professional to ensure you’re complying with relevant laws.
A Real Risk: Hitting Reset On Your Personal Finances
In the right situation, a personal Chapter 7 bankruptcy to pull your business through a downturn can pay substantial long-term dividends. This decision will always mean betting on your business’s future, though. And as small-business owners know far too well, the only sure thing is that there’s no sure thing.
This strategy is cashing in your short-term personal financial position and letting it ride on your long-term business prospects. For an entrepreneur with a realistic outlook, this might prove to be a savvy move. Just make sure you’ll be able to stomach losing the bet and that the potential rewards are worth the risk.
The information provided here is not legal advice and does not purport to be a substitute for the advice of counsel on any specific matter. For legal advice, you should consult with an attorney concerning your specific situation.