Understanding Business Bankruptcy: Types and How to File

Navigating the Complexities of Business Bankruptcy

Small business owners facing insurmountable debt may need to consider bankruptcy as a viable option to alleviate financial pressures. But what types of business bankruptcy exist, and how does one decide which path to take? Ultimately, understanding the types and processes of business bankruptcy can help owners make informed decisions on the best path to financial recovery.

What Is Business Bankruptcy?

Definition and High-Level Overview

Business bankruptcy is a legal process for businesses unable to repay their outstanding debts, typically resulting in various outcomes depending on the bankruptcy type filed. At its core, bankruptcy provides a structured pathway for financially distressed businesses to either liquidate assets or reorganize their operations.

Bankruptcy for businesses is managed through federal courts and governed by the U.S. Bankruptcy Code, specifically Title 11. The process can lead to either the liquidation of the business’s assets to pay off creditors (Chapter 7) or restructuring the company’s debt with a feasible repayment plan (Chapters 11 and 13). According to the U.S. Department of Justice, bankruptcy courts have subject-matter jurisdiction over all cases arising under Title 11, and any decisions are made by appointed bankruptcy judges.

Roles in the Bankruptcy Process

Various key roles are involved in the business bankruptcy process:

• Bankruptcy Judge: An appointed official who oversees the legal proceedings and decisions related to the bankruptcy case.
• Trustee: Typically appointed in cases like Chapter 7 to manage the sale of the company’s assets and distribute the proceeds to creditors.
• Debtors: The business entity filing for bankruptcy. They must disclose all financial information, including assets, liabilities, income, and expenditures.
• Creditors: Entities owed money by the business. They are given the opportunity to file claims and can participate in some aspects of the proceedings.

General Process and Requirements

Filing for bankruptcy involves several critical steps, beginning with the petition filing. The business must file a petition with the bankruptcy court, listing detailed information about assets, debts, and liabilities. The venue for filing is determined based on the location of the business’s principal assets or its primary place of business.

Once the petition is filed, the court assumes control, and an automatic stay is issued, preventing creditors from pursuing further collection activities. During the proceedings, the courts assess the business’s financial situation. Depending on the type of bankruptcy, the outcome might range from liquidation of assets (Chapter 7), enabling business’s continued operation while repaying debts under a new plan (Chapter 11), to simpler reorganization processes for sole proprietors (Chapter 13).

Chapter 7 Business Bankruptcy: Liquidation

Chapter 7 bankruptcy is often pursued by businesses that can no longer continue operations and must liquidate their assets to pay off debts. But what exactly does this entail, and which businesses are eligible?

What Businesses Are Eligible?

To qualify for Chapter 7 business bankruptcy, a business must be insolvent, meaning its liabilities exceed its assets. Eligible entities include corporations, partnerships, limited liability companies (LLCs), and sole proprietorships. For businesses owned by individuals such as sole proprietorships, the owner must pass a means test that evaluates income and expenses.

Additionally, the debtor cannot have had a previous bankruptcy case dismissed within the preceding 180 days due to violations, and they must complete credit counseling from an approved agency within 180 days before filing.

Process and Outcomes

In a Chapter 7 bankruptcy, the assets of a business are liquidated to pay its creditors, with secured debts taking precedence over unsecured debts. The process begins with the appointment of a trustee who oversees the sale of non-exempt business assets. The proceeds from these sales are distributed among creditors. It’s important to note that corporations and LLCs do not get their debts discharged in Chapter 7; instead, their assets are liquidated, and the business ceases operations. Sole proprietors, however, can receive a personal discharge of business debts, making it a viable option for service-based businesses with few assets.

Advantages and Disadvantages

Advantages

1. Immediate Relief: Filing for Chapter 7 bankruptcy provides immediate relief from debt collection efforts such as lawsuits, wage garnishments, and creditor harassment due to the automatic stay provision.
2. Permanent Debt Discharge: Owners of sole proprietorships can receive a personal discharge of eligible unsecured debts like credit cards, medical bills, and personal loans, offering a fresh financial start.
3. Quick Process: The Chapter 7 process is relatively quick, typically taking 3-6 months to complete, allowing business owners to move on promptly.

Disadvantages

1. Credit Impact: Chapter 7 remains on the business owner’s credit report for up to 10 years, causing a significant drop in credit score initially.
2. Loss of Non-Exempt Assets: Non-exempt assets such as additional homes, expensive vehicles, and valuable collections are liquidated, which may result in significant asset loss.
3. Limitations on Dischargeable Debts: Certain debts such as student loans, taxes, and child support are generally not dischargeable under Chapter 7.

Understanding the distinct features and consequences of Chapter 7 can help owners determine if this liquidation approach is their best option.

Chapter 11 Business Bankruptcy: Reorganization

Eligibility and Suitability

Chapter 11 bankruptcy allows businesses to reorganize their debts while continuing operations, making it suitable for companies with potential for long-term viability.

Chapter 11 is intended for businesses facing significant debt but possessing the potential for future profitability. Both large corporations and small businesses can file under Chapter 11, provided they can propose a feasible reorganization plan to their creditors.

Reorganization Process

The Chapter 11 process involves several key steps designed to manage debt restructuring effectively while maintaining business operations:

1. Filing a Petition: Initiating Chapter 11 proceedings involves filing a petition with the bankruptcy court. This action triggers an automatic stay, halting all collection activities against the business.
2. Debtor in Possession: The existing management typically remains in control as the debtor in possession, continuing business operations and proposing a reorganization plan.
3. Reorganization Plan: Within 120 days (extendable up to 18 months), the debtor must submit a reorganization plan. This plan must classify different types of creditor claims—priority, secured, unsecured, and equity security interests—and outline how each class will be treated. The plan may include measures to increase revenue, reduce expenses, or dispose of assets.
4. Creditors’ Vote: Creditors vote on the proposed plan. For approval, a majority of creditors holding at least two-thirds of the total debt amount must accept it.
5. Court Confirmation: If the plan meets statutory requirements and creditor approval, the bankruptcy court holds a confirmation hearing. Once confirmed, the plan becomes a binding agreement between the debtor and creditors.
6. Implementation: The business executes the reorganization plan over a typical period of 3-5 years. The plan’s success hinges on the debtor’s ability to adhere to the projected restructured debt payments.
7. Discharge of Debts: Upon fulfilling the plan obligations, remaining eligible debts may be discharged, allowing the business to continue operations with a reduced debt load.

Examples and Case Studies

Several notable businesses have successfully navigated Chapter 11 to emerge stronger:

• General Motors: Filed in 2009, completed restructuring within 40 days by significantly reducing debt and renegotiating contracts, ultimately returning to profitability.
• American Airlines: Emerged from Chapter 11 in 2013 after merging with US Airways, resulting in a stronger market position and operational efficiencies.

Through understanding Chapter 11, businesses can explore restructuring strategies that allow them to maintain operations and recover financially.

Chapter 13 Business Bankruptcy: Simplified Reorganization for Sole Proprietors

Who Can File for Chapter 13?

Chapter 13 is another reorganization bankruptcy option, particularly practical for sole proprietors with relatively small debt loads.

Unlike Chapter 11, Chapter 13 bankruptcy is specifically designed for individuals, which includes sole proprietors. To be eligible for Chapter 13, the filer must meet several key criteria:

1. Individual Status: Only individuals and sole proprietors can file for Chapter 13. Business entities like corporations or LLCs are ineligible and must opt for Chapter 11.
2. Regular Income: Applicants need verifiable regular income to fund their repayment plan. This can come from wages, self-employment, pensions, or Social Security.
3. Debt Limits: Unsecured debts must be below $419,275, and secured debts must be under $1,257,850 (as of 2022, these limits are periodically adjusted for inflation).
4. Filing History: The filer must not have had a Chapter 13 discharge in the last 2 years or a Chapter 7/11/12 discharge within the last 4 years.
5. Tax Filing Compliance: The filer must be current on tax return filings for the four years preceding the bankruptcy.
6. Repayment Plan Feasibility: The proposed repayment plan must demonstrate that all disposable income will go towards paying creditors.

Process and Requirements

Filing for Chapter 13 involves several detailed steps.

1. Credit Counseling: Before filing, the debtor must complete credit counseling from an approved agency within 180 days prior to filing.
2. Petition Submission: The debtor submits a petition along with a comprehensive list of assets, liabilities, income, and expenses; and a detailed repayment plan based on the debtor’s disposable income.
3. Automatic Stay: Once filed, an automatic stay stops all collection activities by creditors, including foreclosure proceedings, thus providing the filer time to reorganize their financial affairs.
4. Repayment Plan Confirmation: The court reviews the repayment plan, and creditors can voice objections, but ultimate approval rests with the court.
5. Repayment Period: The filer makes regular payments to a court-appointed trustee over a 3-5 year period. The trustee then disburses payments to creditors as per the approved plan.
6. Discharge: Successfully completing the repayment plan results in the discharge of remaining eligible debts. Certain obligations like alimony and child support must be paid in full during the plan.

Advantages and Limitations

Advantages

1. Asset Retention: Unlike Chapter 7, Chapter 13 allows debtors to keep their property. This includes essential business assets, which can be crucial for sole proprietors.
2. Debt Reorganization: Chapter 13 provides a structured method to reorganize and reduce debts over a manageable timeframe (3-5 years).
3. Avoid Foreclosure: It can stop foreclosure proceedings and spread arrear payments over the life of the repayment plan, thereby saving one’s home.
4. Protections against Creditor Actions: The automatic stay provides immediate relief from collections, giving the debtor breathing space to arrange finances.

Limitations

1. Eligibility Restrictions: Business entities are not eligible; only individuals and sole proprietors can file.
2. Duration and Commitment: The commitment to a 3-5 year repayment plan requires rigorous financial discipline, including living below one’s means.
3. Impact on Credit: Filing for Chapter 13 will affect one’s ability to borrow money for years, potentially hindering future business financing opportunities.

Recognizing the scope and limitations of Chapter 13 can help sole proprietors select the most feasible strategy for managing their debts.

Steps to File for Business Bankruptcy

Filing for business bankruptcy requires meticulous planning, beginning with determining the most appropriate type of bankruptcy for your specific situation.

Determining the Appropriate Chapter

The first step in the bankruptcy filing process is deciding which chapter of bankruptcy to file under. Chapter 7 is ideal for businesses that are beyond recovery and need to liquidate their assets. Chapter 11 is suitable for companies that believe restructuring debt will allow them to continue operations. Chapter 13, while typically used by individual sole proprietors, offers a simpler reorganization plan over three to five years.

Filing the Official Bankruptcy Petition

Once the appropriate chapter has been determined, the next step is filing an official bankruptcy petition in the jurisdiction where the principal place of business is located. The filing fees vary by chapter: $338 for Chapter 7, $1,738 for Chapter 11, and $313 for Chapter 13.

Completing Necessary Bankruptcy Forms

The petitioner must also complete and submit various bankruptcy forms as required by the court. These forms typically include schedules of assets and liabilities, current income and expenditures, executory contracts and unexpired leases, and a statement of financial affairs. The cost of attorney fees can vary significantly, ranging from $750 to $4,500 depending on the complexity of the case.

Getting Reorganization Approved

In the case of Chapter 11 bankruptcy, getting a reorganization plan approved involves several steps. Initially, the debtor has a 120-day exclusivity period to propose a plan, which can be extended up to 18 months by the court. Next, a disclosure statement must be filed and approved by the court before creditors can vote on the plan. Creditors holding two-thirds of the dollar amount and a majority of the number of claims must accept the plan for it to be confirmed. Finally, a confirmation hearing is held where the court ensures that the plan meets all legal requirements, at which point a confirmation order is issued, making the plan binding on all parties.

Following a structured approach and seeking legal advice can streamline the bankruptcy filing process, helping businesses navigate this challenging time.

Making Informed Decisions about Business Bankruptcy

Navigating the complexities of business bankruptcy is crucial for any small business owner facing insurmountable debt. By thoroughly understanding the types of bankruptcy and the filing process, business owners can make informed decisions that pave the way to financial stability.