Small Business Bankruptcy: An Option When You Can’t Pay Your Debts

Small business bankruptcy is something no business wants. But when the company can’t pay its debts and creditors demand payment now, filing for bankruptcy could bring some relief. Read these tips from our interview with an experienced bankruptcy attorney.

Bankruptcy.

That’s a term no business wants to think about. Yet there has been a spate of bankruptcies filed by big-name companies in 2020 and small companies are closing up shop in huge numbers. Yelp reports that as of July 2020, 72,842 small businesses that were listed on their site had permanently closed. Those permanent closing amounted to 55% of all the businesses that had first closed temporarily due to the COVID-19 pandemic. Experts expect there will be even more bankruptcy filings by small businesses and individuals resulting from the pandemic.

In some cases, the filings will come after all the pandemic-related loans are used up and can’t be repaid and when moratoriums on evictions for default on leases and mortgages expire. In other instances, bankruptcy filings will come sooner as other types of creditors demand to be paid.

What should you do if you can’t pay your bills?

Sadly, those facts point to even more small businesses running into serious financial problems. So what should you do if your business can’t pay your creditors and they aren’t willing to negotiate longer terms or changes in your agreements? What should you do when you can no longer borrow from Peter to pay Paul because Peter and Aunt Jane and Cousin Maurice are demanding you pay them back, too?

“For moral reasons, or because they think bankruptcy has a terrible stigma, it’s hard for small business owners obligated on the debts of their business to come to the realization that they should file for personal bankruptcy,” says Andrew M. Thaler, founding member of Thaler Law Firm PLLC. “Sometimes even very sophisticated people put their head in the sand and put off doing anything far too long.” Thaler has more than 30 years of experience as a bankruptcy and insolvency practitioner in New York. He has also served as a Chapter 7 Panel Trustee for the United States Bankruptcy Court for the Eastern District of New York since 1990, overseeing liquidation of assets of individuals and businesses on behalf of unsecured creditors.

Waiting too long to file for bankruptcy, if it becomes necessary, can be a big mistake. While the process is complicated and stressful, the benefits often outweigh the alternative of doing nothing.

What are the benefits of filing for bankruptcy?

Filing for bankruptcy can help small business owners and individuals in several ways, not the least of which is reducing the stress of having creditors constantly harassing you with demands to be paid. Among the benefits Thaler cites are:

Automatic Stay – Filing bankruptcy invokes an automatic stay that stops almost all lawsuits and collection efforts.
Exemptions – Federal and State Laws provide for exemptions, which are assets an individual can keep from the reach of creditors in a bankruptcy. There are no exemptions for businesses.
Discharge of Most Debts – Individuals can discharge most credit card debt, loans, and other debts – but for public policy reasons, certain debts survive such as domestic support obligations, debts procured by fraud and fiduciary taxes to name a few. This applies to all chapters of bankruptcy but a “discharge” in a Chapter 11 is somewhat different in that the old debt is replaced with a new obligation that has to be paid under a plan of reorganization.
Rejection of Contracts – You can walk away from undesirable contracts such as long-term building, apartment, or vehicle leases
Reorganize Financial Affairs – You get to work out a plan to pay creditors over time and may only have to pay a percentage of what you owe.
Means Testing – With income down, now may be a window for high earners to be eligible for Chapter 7 bankruptcy. There is a six-month look back on income to be eligible for bankruptcy. If someone was out of work or earned less money in the lookback period because of COVID for example, they might now qualify for bankruptcy whereas at a different time with their prior earnings they would not.

“The automatic stay is one of the biggest things reasons for filing a bankruptcy both for corporations and individuals,” says Thaler. “It stops anybody from doing almost anything that deals with your property. It stops any litigation. People can’t start litigation, can’t continue with the litigation, can’t go forward with an eviction, can’t go forward with foreclosure, can’t go forward with a seizure of a bank account. Everything stops.”

Once the stay is in place, all actions against you go to one place, which is the bankruptcy court. Then, the bankruptcy court decides which things may or may not be able to go forward.

What are the disadvantages of filing for bankruptcy?

While there isn’t as much of a stigma about filing for bankruptcy as there was in the past, there are still disadvantages.

First, filing for Chapter 11 bankruptcy will distract you from running your business, since you will have to spend a lot of time consulting with your attorney, attending court hearings, and gathering the information you’ll need to document assets and liabilities, income and expenses, contracts, property owned, a list of creditors, and other items.

Another problem is that your business will be “subject to oversight by the bankruptcy courts and creditors,” says Thaler. “Creditors can subpoena your books and records and examine you at a deposition where the debtor will be asked a broad range of questions, including inquiries about bank accounts, all assets, contracts, and anything else that relates to the debtor’s assets and liabilities.”

As you might expect, filing for bankruptcy will have a negative effect on your business credit score. And, if you’re planning to continue your business, you may find suppliers will be unwilling to sell to you or may require you to pay cash up front for all purchases until you have re-established your business and credit record.

If you are personally liable for the business debts, either because you are a sole proprietor or you have co-signed or guaranteed debt, then your personal credit standing could be affected, as well.

When should one talk to a bankruptcy attorney?

The best time to talk to an attorney about bankruptcy is as soon as you fall behind on your debts and do not see how you will be able to pay them. Tell-tale signs, says Thaler, include such problems as getting dunning letters from creditors and calls from collection agencies, being sued by creditors you can’t pay, tapping out your bank line of credit and all your credit cards, borrowing against your home to pay the business bills (and then struggling to pay the home equity line of credit payments on time), not being able to make payroll or rent, and starting to be concerned about whether you’ll lose your business or home or both.

What do you stand to lose by filing for bankruptcy?

While people often think of bankruptcy as throwing in the towel and “losing it all,” that is not always true. There are several types of bankruptcy and depending on a business’s circumstances and the chapter of bankruptcy filed, bankruptcy might help a business survive long term. However, even if you have to close the business down and liquidate the assets, there may still be some options available to an individual to protect personal assets.

Types of business bankruptcies

The most well-known forms of bankruptcy are:

Chapter 11 and its new, less costly Subchapter V variation, are for businesses that want to restructure their debt and expect to be able to pay back creditors over time. Both the traditional Chapter 11 and Subchapter V provide a way for businesses to stay open while they pay back their debts.

Chapter 13 is for debt adjustment and reorganization for individuals only, which might be suitable for some sole proprietors.

Chapter 7 is for those businesses and individuals who really are ready to throw in that proverbial towel. For individuals, this chapter wipes out all dischargeable debt. But, it also subjects all non-exempt assets to liquidation. Chapter 7 might be considered by an individual who can’t see their way to recovery, and are not concerned about losing non-exempt assets or by a business that wants a trustee to liquidate its assets in an orderly fashion.

Exempt assets are those assets which an individual is allowed to retain, such as equity in a car, home, or tools of the trade up to certain values established by law.

When should a business use Chapter 11 or Subchapter V to file for bankruptcy?

Businesses that have income and see a path to profitability and a way to repay creditors in the future may be good candidates for one of these forms of bankruptcy. Each of these two forms of bankruptcy allows a business to construct a plan for paying creditors a certain amount of money over a period of time.

For instance, one bankruptcy case Thaler’s firm handled involved a profitable company that had several owners. A dispute between the owners developed and resulted in one of the owners leaving the company and filing a lawsuit to get paid for his portion of the company. The settlement and legal fees to pay off that former owner amounted to more money than the company could afford to pay out immediately.

Thaler’s firm had the company file under the new Subchapter V bankruptcy rules “to get the benefit of the automatic stay, which stopped that creditor from seizing the company’s bank accounts. The bankruptcy, in this case, was used to let the company follow a plan to pay out the money over time and avoid the company being closed.

A potential seizure of assets is just one example of the kinds of situations that could make it beneficial to file for bankruptcy to keep a business going. Other situations could be if money were embezzled or the company saw a loss of revenue and increased debt it could not service attributable to an obsolete product but which the company was able to turn things around with a new product that increased profitability but not at a pace sufficient to immediately satisfy creditor claims. The key is whether a business will be profitable on an ongoing basis and capable of formulating a viable plan to pay off the restructured debt.

Do you have to pay off the entire debt?

The amount of money the business will have to pay creditors under a Chapter 11 plan isn’t necessarily 100%. The amount might be “a certain percentage on the dollar going forward based in an amount not less than what unsecured creditors would receive if all the assets of the business were liquidated in a Chapter 7,” explains Thaler. “And because you want to continue that business, the company will have to pay creditors some portion of the profits of the company over a projected period of years, usually 5 years or less.”

What’s the difference between Chapter 11 bankruptcy and Subchapter V?

There are many differences between Chapter 11 and Subchapter V. The traditional Chapter 11, because of all its complexities, can be very expensive and is more geared towards and practical for larger businesses. Subchapter V, which was established to make it easier for small businesses to file, eliminates some of the complexity, lowers the cost of filing, and makes it easier for the business owners to maintain an ownership interest in the business. Among other benefits of filing under the Subchapter V statute are that there is no Disclosure Statement, you don’t necessarily have to send a plan out to creditors for voting, and you can more easily retain ownership of the company while you are paying off debtors under the plan you establish.

What should small business owners know about filing Chapter 7 bankruptcy?

Filing for Chapter 7 bankruptcy can be perilous for closely-held businesses in which an owner has used business funds to pay personal expenses such as a child’s tuition, a spouse’s car payments, or the mortgage on their home. Comingling funds in this way legally could be considered a basis for piercing the corporate veil and could make the owner(s) personally liable for the business debt. The term “piercing the corporate veil” means the court takes away the liability protection of an LLC or corporation because the owners engaged in improper conduct such as fraud, commingled funds, or other activities that invalidated the protection of the business’s corporate or LLC structure.

In addition, a small business owner operating as a corporation or LLC might be liable for the business debts if they personally guaranteed business credit cards, loans, or other debt.

Chapter 7 personal bankruptcy can be a viable bankruptcy choice for small business owners. Assets that can be retained and kept away from creditors include:

A certain amount of equity in one’s home
Household goods
Most pensions
Most tools of a trade
A motor vehicle worth up to $4,425
Personal injury recoveries up to a certain dollar amount
Most life insurance and annuities

How to avoid the problems caused by bankruptcy

If you do reach a point in your business when you can’t pay your debts, don’t put off contacting a bankruptcy attorney. When you meet, the attorney will ask a lot of questions to help determine the best plan moving forward to deal with the situation. He or she will want to know if you would like to continue the business and if you have a realistic way of moving forward to bring in enough money to do so. And if you do need to file for bankruptcy, the attorney will provide the facts to help you select which form of bankruptcy to file.

But, as with most legal issues, the best way to avoid problems is to know in advance what could go wrong, and then take steps to protect oneself. When you start your business, consult with an accountant and an attorney about the best form of business to operate under for tax purposes and what you’ll need to do to run the business in a way that will help you avoid being personally liable for business debts, should the business fail or be sued.

Note: the preceding information is provided as a general overview of what is involved with small business bankruptcies. It is not legal advice. If you are in need of legal advice contact a local attorney.