The Different Types of Business Bankruptcy

For small business owners, bankruptcy can feel like an obscenity to say out loud. When you read about big corporations going bankrupt in the news or hear entrepreneur friends share that their small businesses filed for bankruptcy, it sounds like they’ve reached a tragic end.

The truth is that bankruptcy doesn’t mean you’ll never work again—it doesn’t even mean that your business has to shutter for good. While the bankruptcy process for small businesses can be traumatic, expensive, and financially damaging, there are ways to mitigate the stress of bankruptcy as well as methods to protect your business and your assets during the process.

Knowing the different options available for small businesses considering bankruptcy is the first step. Before you contact a lawyer or your creditors, think about which type of bankruptcy might fit your situation best.  

What Is Bankruptcy?

Bankruptcy is a legal proceeding decided in federal court involving an individual or company that is unable to repay outstanding debts. Typically, the process begins with a filing on behalf of the debtors, although occasionally debtors can begin the process with the court. During the process, the court takes into account the debtor’s assets. Depending on the type of bankruptcy, the types of debt involved, and the business’s structure, the court may decide that the assets are used to repay debts.

It’s common knowledge among entrepreneurs that most small businesses fail: Bureau of Labor data shows that about 50% of small businesses close within 5 years of opening. However, not every business that closes files for bankruptcy. Most companies that consider bankruptcy are having issues with repaying debt.

Still, small business bankruptcies happen all the time. In the first quarter of 2021, a study found that there were 6,289 commercial bankruptcies in the United States.  

You often hear the different types of bankruptcies referred to as “chapters”—this refers to their chapter in the US Bankruptcy Code. Another recent survey of small businesses found that of respondents that filed for bankruptcy, 51% filed for Chapter 7, 22% filed for Chapter 11, and 27% filed for Chapter 13. We’ll talk more about these chapter types below.

When Should a Business File for Bankruptcy?

Instead of thinking about how successful—or not—your business is, when considering bankruptcies, think most about your debts and your ability to repay them.

“The truth is, if your business is consistently unable to keep up with your debts and expenses, it’s already bankrupt—or on a very short trajectory towards it,” explains Meredith Wood in AllBusiness. “Filing for bankruptcy protection is meant to help you get out of this untenable situation and keep many of your personal assets. You may be able to keep your business open while you pay off debt by reorganizing, consolidating, and/or negotiating terms.”

Filing for bankruptcy can lead to the closure of your business, but it can also be used to save your company by allowing you to renegotiate your debt situation. Either way, it doesn’t foreclose your ability to start another business in the future.

“While filing for bankruptcy does take recovery time, it isn’t the all-time credit-wrecker you may think,” Wood continues. “Typically, after 10 years, it is removed from your credit history, and you’ll likely be able to get financing several years before that.”

If you feel like your debt and business expenses are overwhelming your small business’s ability to continue, you should think about bankruptcy. The next step is to determine what type of bankruptcy represents the best way to move forward.  

The 3 Types of Small Business Bankruptcy

The 3 main types of bankruptcies utilized by small businesses are Chapter 7, Chapter 11, and Chapter 13. There are even more forms of bankruptcies for individuals, companies, and cities, but these 3 types are the main commercial options available to you.

The type of bankruptcy you pursue will mostly depend on how your business is structured and how you plan to move forward after filing bankruptcy.

Importantly, any bankruptcy filing places a temporary stay on your creditors and puts your repayments on hold while the court considers your situation.

Chapter 7: Liquidation

In Chapter 7 bankruptcy, a company is closed and its assets are liquidated in order to pay off its debts. In the popular imagination, this situation is likely the one most people think of when they think about bankruptcy. If you believe your small business has no viable future, Chapter 7 might be your best option. Chapter 7 might also make sense if your business doesn’t have a lot of assets to begin with.

Sole proprietorships file a personal Chapter 7, which takes into account both personal and business debts.

When Chapter 7 proceedings start, a “means test” is conducted on the applicant’s income. If the income is over a predetermined level, the application is denied. Next, the court appoints a trustee to take over the company’s assets, liquidate them, and distribute them amongst the creditors.

If it is a sole proprietorship case, a discharge is issued after the creditors are paid, meaning the business owner is no longer obliged to pay any more of the debt in question.  

Chapter 11: Reorganization

If you think your business can continue after bankruptcy, filing for Chapter 11 might represent your best choice. In this type of bankruptcy, the debtor plans to reorganize so that it can repay its debt while continuing operations. Working with a trustee and your creditors, you’ll have to devise an expansive plan that shows how you can repay your debt. Your plan must ultimately be approved by your creditors.

Chapter 11 is commonly talked about in the financial press, but it can be a hard process to navigate for small businesses.

“While Chapter 11 is designed to give distressed but viable businesses a second chance, it has a very poor track record with small and medium-sized companies,” a report from the Brookings Institute notes. “The costs of bankruptcy for small and medium-sized businesses are substantial—often 30% of the value of the business—and two-thirds are liquidated rather than reorganizing.”

There are good reasons to suspect that a Chapter 11 bankruptcy might work best for you if you don’t want to shut down. However, going this route can be expensive and lengthy—many proceedings take a year or longer to complete. It’s worth it to contact a qualified bankruptcy attorney if you want to explore Chapter 11.

Chapter 7 vs. Chapter 11

As complex as it is, you might want to research Chapter 11 if you feel like your business can continue with restructuring.

“The only reason you need to use Chapter 11 at all is to deal with recalcitrant creditors,” bankruptcy lawyer Bob Keach told the New York Times. “If creditors won’t negotiate with you, bankruptcy allows you to cram down a plan of restructuring.”

Remember, filing for Chapter 7 doesn’t mean you can never open another business, although financing might be more difficult to find at first.

Chapter 13: Reorganization for Sole Proprietors

If you’re a sole proprietor with a high income, you can file Chapter 13 bankruptcy. This allows you to keep your assets and property if you agree to a new repayment plan with your creditors. These plans usually last 3 to 5 years.

Does Filing for Bankruptcy Mean Going out of Business?

If you file for Chapter 7 bankruptcy, your business is closed and its assets are liquidated. If you file for Chapter 11, you’ll be allowed to keep your business open under a new plan with your creditors.

Will Business Bankruptcy Affect Me Personally?

A business bankruptcy could impact the business owner if your personal assets were used as collateral for your debts. Importantly, though, you will not go to jail for not paying a business loan.

“It depends on what personal guarantees you made,” Amy Haimerl writes in the New York Times. “Most small business owners put up their home or some other asset as collateral for start-up loans…If you used your house as collateral, it’s possible you would be forced to sell it as part of a Chapter 7 settlement. Under Chapter 11, you may have more luck.”

If you’re a sole proprietor and you file for Chapter 7 but fail the means test, you can file for Chapter 13. However, your repayment plan will be based on your income.

One of the big differences between personal and business bankruptcy is the means test. Individuals have to participate in a means test to determine if they are eligible for a Chapter 7 or a Chapter 13, while businesses do not have to undergo this for a Chapter 11 filing.

If your business is structured as a limited liability company (LLC) or a corporation, then your personal assets should be protected unless you used them to secure a loan.

If you file for bankruptcy as a sole proprietor, your personal credit score will lower significantly. Chapter 7 and Chapter 11 bankruptcies stay on your credit report for up to 10 years, while Chapter 13 bankruptcies stay on your credit report for up to 7 years.

If your business is an LLC or a corporation, its bankruptcy filing shouldn’t impact your personal credit score. However, if you personally guaranteed one of the company’s loans and you fail to repay, your credit score could be dinged.