When Is Bankruptcy the Right Choice for a Small Business?

by Kevin Casey on May 17, 2012
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Small businesses fail for many reasons, including some beyond the owner’s immediate control. It’s a reality of entrepreneurship: Not every new business will succeed, and sometimes even long-standing companies hit hard times.

Bankruptcy is an option when a debt-laden business is failing, but it’s not always the right one. Even when it is the best choice, there are multiple types of bankruptcy filings, each with its own advantages and disadvantages. The Intuit Small Business Blog asked attorney Michael J. Duffy, who specializes in bankruptcy and business law, to help sort through the do’s and don’ts of filing for bankruptcy.

Your Assets at Risk

Duffy says small-business owners should only consider bankruptcy if their personal assets are at risk. “If only a limited-liability business entity were suffering financial trouble, the best thing to do is just close the doors and walk away,” he says. “There’s no need to go through any bankruptcy process if the only recourse is against the business.”

As a result, Duffy typically recommends that new business owners organize their enterprise as a corporation, LLC, or other limited-liability entity to help protect their personal assets from business creditors. (Businesses that operate as sole proprietorships or partnerships expose their personal assets to greater risks.) But even when you’ve set up a limited-liability structure for your company, your personal assets may still be in jeopardy, depending on how you run your business, Duffy says.

One common reason: improperly separating your personal and business finances. When that happens, he explains, “The court will find that there was no separate business entity, disregard it, and ‘pierce the corporate veil,’ putting the owner’s personal assets at risk.”

Another common reason: Banks and other creditors usually aren’t eager to extend financing to new limited-liability entities. That’s because the creditor won’t have sufficient means for recovering its money if the business fails. As a result, significant amounts of credit — startup capital, commercial leases, lines of credit, and so on — often require a “personal guarantee,” meaning the owner must put his or her personal assets at stake to get approved for financing. “The [business owner’s] assets are then just as vulnerable as if there was no corporate entity,” Duffy says. “In many cases, the financing is also secured by personal collateral, such as a home.”

Types of Bankruptcy

When personal assets, such as a home, are at stake in a business failure, bankruptcy may be the best way to protect them from creditors. Choosing which type of bankruptcy to file for can be complicated, because it hinges upon on state laws and a host of other variables, Duffy says. Understanding the basics can help reduce some of the fears and misconceptions that surround the process.

First, let’s dispel a myth: If you’re considering a bankruptcy filing, it’s unlikely to be the type most people first think of.

“You’ve probably heard of Chapter 11, but that’s generally only useful for larger-scale operations, particularly publicly traded companies,” Duffy says. That’s because it’s time-consuming and costly for all involved. “In most cases, if a business is failing, creditors, such as banks, want to cut their losses and liquidate. They’re not interested in going through a complicated and expensive process of reorganizing the company.” (Duffy notes one exception: Chapter 11 may provide the best outcome for business owners who have a high personal net worth and regular income.)

The far more likely choice for a small business will be either Chapter 7 or Chapter 13, he says. In the simplest terms, Chapter 7 is a liquidation that effectively marks the end of the business. Chapter 13, on the other hand, is a repayment plan that could enable the business to stay afloat and succeed in the future.

The debtor’s income, assets, amount owed, and financial goals are key criteria in choosing between Chapter 7 and Chapter 13. The court may make the choice for you. Low (or nonexistent) income and asset value combined with a large amount of debt make Chapter 7 more likely; higher income and asset value combined with lower debt make Chapter 13 the probable path.

How to Stay Out of Trouble

Duffy offers some advice for avoiding bankruptcy scenarios in the first place: Whenever possible, avoid using your personal assets to start or operate your business. If your business does hit bumps in the road, consider cutting back rather than “doubling down.”

“It’s better to retreat and regroup than go big and be wiped out,” he says.

Last, but most definitely not least: Write a business plan, Duffy urges. “So often the losses that lead to bad financing decisions can be easily avoided if there is a proper business plan that is followed.”

In a future post, we’ll examine some practical alternatives to bankruptcy. Stay tuned!

Kevin Casey is a business writer for Intuit and is passionate about solving small business problems.

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