Making Sense of Bankruptcy: Should You File a Chapter 7 or Chapter 13 Bankruptcy if You Want to Continue Operating Your Business?

If you have a business that you need to continue of operate, choosing the right form of bankruptcy involves risks and opportunities.

Here’s the sentence that we’re explaining today:

Chapter 7 and 13 are very different procedures if you are continuing to run your business, with Chapter 7 potentially risky if your business or any of its assets is not “exempt”—protected from liquidation—but with Chapter 13 limited in that if your business is in the form of a corporation/LLC it can’t file a bankruptcy separate from you, so that this choice is a delicate one that turns on the facts of your unique situation.

Chapter 7 and Chapter 13 with an Ongoing Business

Chapter 7 “straight bankruptcy” is a “liquidation” procedure: your assets are reviewed by your bankruptcy trustee and any that are not protected (“exempt”) under federal or state law can be sold to pay your creditors. However, in most consumer Chapter 7 cases the laws exempt all of the assets of the person filing bankruptcy and so that person keeps everything they own.  Such a “no-asset” Chapter 7 case usually takes no more than four months from beginning to end. The focus of Chapter 7 is to get all or most of your debts “discharged”—legally written off—so that you get a fresh financial start quickly.

Chapter 13 “adjustment of debts” is, in contrast, an extended payment program, usually lasting three to five years. It allows you to keep all of your assets most of the time, including ones that would not be exempt under Chapter 7. Usually you would file a Chapter 13 case because of the significant advantages it gives over Chapter 7 for dealing with specific debts, such as home mortgages and other liens against your home, vehicle loans, income and withholding taxes, child and spousal support. Also, you may need to file under Chapter 13 if you don’t qualify for Chapter 7 under the “means test” (an income and expense qualification) or because not enough time has passed since a prior bankruptcy case. The focus under Chapter 13 is on the formal payment plan for managing your debts, especially the special ones that it handles in a very favorable way for you.

With Chapter 7 the Risk of Your Business Assets Being Not “Exempt”

Because Chapter 7 focuses on liquidating assets, including the business assets you own, it’s a risky option if you want to keep operating your business.

First, if the business is in the form of a sole proprietorship (you’re doing business under your own name or under an “assumed business name” and not through a corporation, limited liability company (“LLC”), some other similar legal arrangement), then every asset of your business is directly owned by you in the eyes of the law. So if any component of your business is not “exempt,” the bankruptcy trustee could take that component from you (or the entire business) and sell it to pay your creditors. This includes both tangible assets like business equipment and inventory, but also accounts receivable, pending contracts, and possibly even customer lists, brand names, website domains, and any intellectual property.

Also, because under Chapter 7 the trustee technically become the temporary owner of all of your assets, including your operating business, if that business presents some ongoing exposure to liability and you don’t have good business liability insurance (or possibly even if you do), the trustee may require you to shut down your business to avoid the risk of liability for the trustee through the business during the course of the Chapter 7 case.

Second, if your business is not a sole proprietorship but rather operates as a corporation or LLC, then when you file a Chapter 7 case your share of ownership in the business is one of your assets. So, that share of the business is subject to being taken and sold by the trustee to pay your creditors if that share is not exempt. Your business may not have any value, or not much, and so your share in it may have no value or very little. But be very careful of the risk that the trustee could find a willing buyer even for that seemingly not valuable share of the business (again assuming it’s not exempt), including potentially a competitor who would appreciate this opportunity to buy out your business (often at a steep discount) to either take over or simply shut down your business.

Chapter 13 Only Available to “Individuals,” Not Corporations/LLCs

Chapter 13 can usually avoid these asset-based problems because it has ways of protecting assets that are not exempt, and is overall better designed for operating an ongoing business. But it presents a separate potential problem based on the fact that it can only be filed by human beings, not by corporations, LLC’s and such.

So if your business is a sole proprietorship—if you are doing business under your own name or simply under an assumed business name but not under a corporation/LLS—then your personal Chapter 13 filing will cover both you and your business. That’s because the business is not a legal entity separate from you—it does not own assets or owe debts in its own name, only through you.

If on the other hand your business is in the form of a corporation/LLC or similar kind of entity, it can’t file a Chapter 13 case itself. Your personal Chapter 13 case would deal with your personal liabilities, including those related your business (through personal guaranties or other forms of personal liability for business debts), but the business itself would not be protected by your bankruptcy filing. If the business itself has no debts or no debt problems, and so it does not need bankruptcy protection, only you do personally, a personal Chapter 13 case could be your best option.

A Decision to Be Made Cautiously and with Good Counsel

Clearly, there are serious risks to filing a Chapter 7 bankruptcy if you intend to continue operating your business, whether or not it is a sole proprietorship. This does not mean Chapter 7 can never be done effectively and safely in this situation, but you definitely need the advice of a conscientious attorney with significant business bankruptcy experience to determine whether and how to do so.

If your business is in the form of a sole proprietorship, then Chapter 13 could be your best and safest option for continuing to run your business while solving your debt problems. That could also be true even if the business is a corporation/LLC, but likely only if the business itself has no debts or else its debts are current. That’s because your Chapter 13 won’t protect your business which can’t file its own Chapter 13 case. Also if you have a very small businesses having it file a Chapter 11 case is seldom worthwhile because it is prohibitively expensive and inefficient.

So, this choice is clearly a delicate one that requires sophisticated legal knowledge and experience. If you have a business that you want to continue operating while resolving your debt problems, make sure you get the right help to make the right decisions.

Related posts:

How Bankruptcy Handles . . . Income and Withholding Taxes You Owe as the Business Owner of a Sole Proprietorship If Your Business is Eligible to File Bankruptcy, Should It Do So? Making Sense of Bankruptcy: Avoiding the “Means Test” in a Business Bankruptcy Making Sense of Bankruptcy: Should You File a Bankruptcy for Your Closed Business and a Separate One for You Personally? Making Sense of Bankruptcy: What Is a No-Asset Chapter 7 Case?