The House Packard McElderry Blog

Consumer Bankruptcy and Small Business Owners

By Jennifer E. House Packard, February 12, 2015

Throughout the economic downturn and recovery, bankruptcy has becoming a reality for more and more Americans. Many people and small business owners find that their hard work is simply not enough to pull them through financially tough times.  And throughout these tough times, many small business owners have not considered bankruptcy because they fear what would happen to their businesses.  Thus, by the time they come see me, they are so overwhelmed with debt that they are struggling to feed their children and pay their utility bills.  Fortunately, bankruptcy law allows for debt relief for those suffering financial hardship. To avoid the above scenario, small business owners need to know that they have options and what those options are.

The first step in analyzing bankruptcy is to determine whether the small business would file or the owner should file in an individual capacity.  If the debts are solely in the business’ name, and the business is a corporation or limited liability company (LLC), then the company or corporation itself needs to file for relief.  In that scenario, the business has two options: filing under Chapter 7 or Chapter 11.  Chapter 7 is appropriate when a business needs to permanently close and liquidate, in which case restructuring the debts would not be feasible.  Note that under the bankruptcy code, if your business is a partnership, the business itself is not considered a separate legal entity from the general partners, and they may be individually liable for the debts of the business.  Chapter 11 allows for the business to restructure its debts and would be appropriate when a business could be profitable if it were not for the burden of the debts. In Chapter 11, the business may continue to operate and remain in possession of its assets.

After filing under Chapter 11, the debtor (whether an individual or a business) will create a plan in which its debts are restructured. Creditors whose legal rights are affected will be able to vote on the confirmation of the proposed plan.  Chapter 11 is a lengthy and costly bankruptcy and should be entered into with caution.

If the business owner is a sole proprietor, there is no legal separation of the business and the individual.  In that case, a personal bankruptcy is appropriate. More often than not, even in the case of small business owners, it is the individual, not the business, who needs to file for bankruptcy relief.  In addition to sole proprietors, small business owners of an LLC or a corporation may also file personal bankruptcy with little effect on their business.  In that case, the debtor has two options: filing under Chapter 7 or Chapter 13.  Chapter 7 is a complete discharge of the unsecured debts.  Something to keep in mind is that the creditors of an LLC or corporation will still be able to collect against that business entity, even though the individual’s personal guarantee will be discharged.  Relief under Chapter 7 is appropriate when the individual’s income received from the business and all other sources falls below a certain amount set by the IRS.  So long as the business does not have substantial assets exceeding the state exemptions, Chapter 7 is often the best route for a small business owner.  It provides a fresh start for individuals so that they may focus on the success of their business.

Chapter 13 involves individual reorganization and is appropriate when a debtor may be behind on mortgage or car payments, have substantial assets (including assets of the business exceeding the exemptions), or when high income triggers a “substantial abuse” objection if filed under Chapter 7.  Unlike Chapter 11, the debtor proposes a reorganization plan, which the creditors must accept without a vote. The plan will require future monthly income from the business, after personal expenses are met, to be paid into the plan. During the life of the plan, the debtor is protected from creditors.  Further, after the Chapter 13 plan is complete, many of the unsecured debts will be discharged.  The debts of an LLC or corporation may not be included in the Chapter 13 plan.  In other words, Chapter 13 provides relief solely for individual reorganization and will allow an individual to stay in business even if the business has assets and is not the source of the debt.

If overwhelmed with debts, a small business owner has options and will not be required to shut its doors. Bankruptcy can be a powerful tool to help business owners through financially-trying times to achieve a fresh start.

- Jennifer E. House Packard

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