Leaving Your Business

Understanding the Different Forms of Bankruptcy

If you or your small business is overwhelmed by debt, then filing for bankruptcy might be a perfectly acceptable step. While bankruptcy isn’t a decision to be made lightly, it can provide you or your business with a structured way to get out of debt and back on solid financial ground.

What Is Bankruptcy?

Bankruptcy is a legal solution for reducing and/or eliminating debt, whether that debt was incurred by an individual or a business. By filing for bankruptcy, the debtor (the person or entity that owes money) gets legal protection from the actions of creditors. These usually include actions like garnishment of wages, collections calls, lawsuits and home foreclosures.

A debtor can have two different types of debt:

Secured debt: Debt that is “secured” against the value of an asset, such as a house or vehicle. If you default on a loan based on secured debt, the creditor can take possession of the particular item it was secured against if you do not pay. For businesses, debt can also be secured against intangible assets, such as patents, trademarks or intellectual property.

Unsecured debt: On the other hand, unsecured debt isn’t secured against anything. Loans from unsecured debt are made from a borrower’s promise and creditworthiness.

Knowing if your debt is secured or unsecured is important, as creditors that issued secured debt will always be paid first under a bankruptcy agreement.

How to Know If You Need to File

Filing for bankruptcy is a difficult and scary decision to make. If you’re seriously considering declaring bankruptcy, there are basically two factors to consider:

  1. What is the future potential for the business?
  2. How much of the business debt is secured?

You should always consult with a lawyer who specializes in bankruptcy filings to see if it’s right for you and your business.

Should you decide to pursue it, in most instances, you will also be required to receive credit counseling. Once this has been completed via an approved provider as defined by the United States Courts website, you should find an attorney who can help you file your claim. Filing for bankruptcy must be done through a federal court, and can cost several hundred dollars in legal fees.

Below are the details regarding the three most common forms of bankruptcy and how each can affect your business in the short and long term.

Common Types of Business-Related Bankruptcy

Chapter 7 

Sole proprietorships and small businesses that have no viable future or lack substantial assets typically file Chapter 7. In this instance, all of the business’ assets are sold to satisfy debts, and any debts that cannot be covered by the sale of assets are discharged. That’s why Chapter 7 is also commonly referred to as “liquidation.” Chapter 7 also operates under the assumption that you and/or the business do not have sufficient income to pay a portion of your debts. If you have enough income, you will need to file Chapter 13.

Once a business has filed Chapter 7, it is not possible to further conduct business operations, so the business is basically dissolved. If you want to retain your business after bankruptcy, then Chapter 7 is likely not an option.

Chapter 11

This is the most complex and time-consuming type of bankruptcy, and is most commonly filed by businesses. If a business has filed Chapter 11 bankruptcy, it continues to function, keeps ownership of all assets and tries to work out a reorganization plan to pay off its creditors. It’s important to note that debt obligations are not dismissed under Chapter 11, but rather renegotiated, often resulting in longer repayment windows, smaller payments or lower interest rates.

The passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 limits debtors to 120 days to create a plan. After 120 days, if a plan has not been submitted, creditors can submit their own. When a plan is approved by the court, the court will appoint a trustee to supervise the repayment process while the business continues to operate.

Chapter 13

This type of bankruptcy is normally filed by individuals, and may be appropriate for sole proprietorships as well. Similar to Chapter 11, if a debtor files for Chapter 13, he or she retains control of his or her assets while working out a three- to five-year repayment plan. Depending on the debtor’s income, some of the debt may be discharged, or a limit might be placed on the amount of debt involved.

Whichever type of bankruptcy you choose, it’s important to remember that bankruptcy filings will remain on the debtor’s financial record for seven to 10 years. Before filing for bankruptcy, you might also want to consult with a credit counselor who may be able to steer you toward an alternative, such as debt consolidation, which can have a less negative impact on your credit score. As a business owner or entrepreneur, your personal credit score can have bearing on your ability to secure business loans or funding.

Filing bankruptcy is not the end of the world, although it may feel like it. If you approach the filing as a second chance to get your financial life straight, then you’ll reap the benefits of getting a fresh start.

If you’re considering bankruptcy, you probably want to also reduce your debt. Continue on to our article on how to decrease small business debt.

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