When Is it Time to Consider Bankruptcy for Your Small Business

Bankruptcy can help you liquidate a failing business or keep it open while erasing some debts.
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Small business owners may be able to file for Chapter 7 or Chapter 13 on behalf of themselves and/or their business. Learn from the experts to decide which — if any — option is best for you. (Photo: Minerva Studio/Shutterstock)

Declaring bankruptcy is an act no small business owner ever aspires to. But there may come a time when it’s the right thing to do.

How do you know when that moment is upon you?

Before deciding whether to file — and whether to try to stay open under bankruptcy — owners may choose to consult a CPA for advice on cash flow or talk with a business advisor about how to reorganize, said bankruptcy attorney Justin Harelik, founder of Westgate Law.

But most owners see the writing on the wall, he noted. At that point, you’ll want to contact a bankruptcy attorney to find out what options you have based on your business structure, creditor situation and assets.

Related: How to Survive a Cash Flow Crisis

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“Quite often, depending on the business, a business bankruptcy doesn’t make a ton of sense because the individual themselves is still going to be liable.” -Justin Harelik (Photo: Justin Harelik)

Filing for bankruptcy for the business, yourself, or both can potentially erase some of your debts, but it may not provide as much protection from creditors as owners often think, noted Harelik, even if the business is a corporation or LLC.

That’s because corporate structures typically “protect you from little to nothing,” said Harelik, especially if you’ve signed a personal guarantee on the debt, something he said commercial lenders almost always require. In that case, Harelik explained, “all your personal stuff is on the hook as well.”

As a result, he said, “Quite often, depending on the business, a business bankruptcy doesn’t make a ton of sense because the individual themselves is still going to be liable.” He added, “A lot of times I get hired to file bankruptcy and we don’t even file for bankruptcy for the business, we just file for the individual because the business can just sort of go away.”

Types of bankruptcy

Most small business owners will file either Chapter 7 or Chapter 13 bankruptcy. Chapter 11, which is geared toward large businesses that need to reorganize in order to stay afloat, usually isn’t an option.

“Typically the cost of filing Chapter 11 could be $10,000 to $20,000 or more just to hire an attorney, and for a lot of small business owners that’s just cost prohibitive.” -Justin Harelik.

Under Chapter 7, Harelik explained, you’re closing down. “You’re not paying anything back, you’re trying to liquidate all your debt.” A trustee sells the assets and deals with your creditors.

Under Chapter 13, “you’re getting on a payment plan to pay back the debt, some or all of it.” Under such a payment plan, you make installments to a trustee over three to five years. Meanwhile, your business can still operate — and creditors can’t start or continue collection efforts.

Note, however, that a business entity can’t file for Chapter 13; only an individual or a sole proprietor can.

Related: Here’s How to Protect Your Personal Assets from Business Liability

When your retirement funds are at stake

Filing for bankruptcy when your business is hemorrhaging money may be a smart move to protect your retirement savings in the event you’re tempted to tap them for cash.

“If you’re about to withdraw your retirement funds, stop and reassess,” said attorney Cara O’Neill, bankruptcy editor for legal publisher Nolo.

She noted entrepreneurs often have tremendous drive and are used to succeeding — and therefore might wait too long to make the bankruptcy decision. “They have a feeling that as long as they keep going they can find the answer and sometimes, that’s their blind spot. They don’t know when to quit.

“It really comes down to stopping the hemorrhaging before you funnel all your retirement funds into the business,” added O’Neill. “In most cases, I can help someone protect all of their retirement in bankruptcy, but so many business owners drain it.”

For sole proprietors

Depending on your situation and the way your business is structured, bankruptcy may erase certain debts.

If you’re a sole proprietor and need to close the business, you could file for Chapter 7 bankruptcy for yourself and your business “and then all dischargeable debts will get wiped out, including the business debt,” said O’Neill. Dischargeable debts under Chapter 7 may include credit card balances and past-due rent and utilities.

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A good time to file bankruptcy is before you withdraw retirement funds, says Cara O’Neill, bankruptcy editor for legal publisher Nolo. (Photo: Cara O’Neill)

If you’re a sole proprietor and your business is still bringing in money, filing for Chapter 13 can buy you time and give you some breathing room to get on a path to profitability.

“The nice thing is that the filer will be able to restructure the debt and focus on paying important things [like a mortgage and overdue taxes], while paying very little, if anything, on the credit card debt that was probably incurred while trying to keep the business afloat,” said O’Neill.

For Incs and LLCs

If your business is a corporation or an LLC and you plan to close down, you can file for Chapter 7 bankruptcy for the business if you want help liquidating your assets. But otherwise there may be little point.

Filing doesn’t wipe out business debt, noted O’Neill. What’s more, she explained, “there’s really no reason for the debt to get wiped out because once the business is defunct, it won’t generate money that a creditor can collect.

“I rarely recommend a Chapter 7 business bankruptcy. In most cases, it isn’t needed if you wind down the business appropriately. The reason to do it is if you want to show your creditors that you are dissolving assets in a transparent manner. For instance, if the business owns a lot of inventory or equipment, filing for Chapter 7 might make sense. It’s less likely that a creditor will accuse you of personally absconding with the business assets if the trustee takes on the responsibility of liquidating the property.”

O’Neill and Harelik both noted there’s little point in filing bankruptcy for your business if you’ve signed a personal guarantee. “I rarely file a business bankruptcy if an individual owner is liable for business debt. If the owner is a good Chapter 7 candidate, it makes more sense to file a personal bankruptcy because it will wipe out the guarantee,” said O’Neill.

A bankruptcy attorney can help you figure out whether to file for bankruptcy for your business, yourself or both.

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If the money you owe is to small companies that you have built relationships with, it may make more sense to try to negotiate before turning to bankruptcy. (Photo: David Crockett/Shutterstock)

When bankruptcy might not make sense

If you have more liabilities than assets, bankruptcy might make sense. But bankruptcy might be a mistake if when you have too many assets, Harelik noted, especially if you’ve signed a personal guarantee that puts your personal assets at risk. If you file for bankruptcy in that event, you could lose assets including your car or house. (Different states have different exemptions, so talk to your lawyer about what your exposure is.)

Harelik said you might instead liquidate some of the assets and use the money to keep going, then file for bankruptcy if the business is still in trouble.

If you don’t have commercial lenders breathing down your neck and the money you owe is to small companies, such as contractors and small vendors you’ve worked with for years, it might pay to try to negotiate to see if you can pay later or pay less before resorting to bankruptcy.

“They want to get paid something, and they understand if you file bankruptcy they get nothing, so they’re going to work with you to reorganize,” said Harelik.

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