Business Bankruptcy Options: How to File a Bankruptcy

If your business has accumulated a lot of unpaid federal taxes, there might be no other choice but to file for bankruptcy. But how do you file for business bankruptcy, and which way is the least damaging way to go about it?

In this blog, we will explore how a business can file for bankruptcy and provide answers to your most concerning questions. We’ll focus on different types of bankruptcy, from Chapter 7 to Chapter 13, and also offer alternatives to bankruptcy. 

What Is Business Bankruptcy?

Business bankruptcy is a legal procedure that allows a company facing excessive debt to either restructure its financial obligations or liquidate assets. When a business files for bankruptcy, it essentially declares that its debts exceed its assets or that it’s unable to repay them. Bankruptcy gives businesses a chance to start from scratch by relieving debts they cannot pay while providing an alternative way to pay off creditors in an orderly manner.

However, filing for bankruptcy doesn’t mean you’re admitting defeat. On the contrary, it can be a proactive step to resolve your financial commitment in a structured way. It can help you preserve your business and keep your main operations running, or it may facilitate the closure of your company without any legal repercussions. 

Many businesses choose to go bankrupt to protect themselves from legal consequences and ensure creditors receive as much repayment as possible under legal supervision.

Types of Business Bankruptcies

There are several types of business bankruptcies. These types cater to different businesses and have different eligibility requirements. Let’s take a look at each of them in more detail:

Chapter 11 Bankruptcy

Chapter 11 bankruptcy, sometimes referred to as “reorganization” bankruptcy, allows the company to remain operational and to create a mutually agreed repayment plan with its creditors. This might typically involve downsizing operations, renegotiating debts, or liquidating assets to pay creditors. Big corporations, partnerships, and LLCs usually go for this option, but small businesses can also sometimes benefit from it.

Here’s how Chapter 11 bankruptcy works: 

• When you file for Chapter 11, you have to come up with a reorganization plan within 120 days after the filing date. This plan should outline the methods for handling debts, obligations, and operational adjustments. In some cases, you could extend this timeline to 18 months with court approval.
• The business, thus referred to as the “debtor in possession,” continues its operations but under the supervision of the court. The company maintains control over its assets and operations during the restructuring phase – something that sets this type of bankruptcy apart as the most favorable one for the business.
• Creditors are categorized into classes based on the nature of their claims, after which they must vote to approve the reorganization plan. The court must also approve your plan later to make sure it is fair and feasible.

While the ability to continue operations makes Chapter 11 the most favorable bankruptcy type for businesses, it can also be complex and costly. The legal proceedings and attorney fees can be high and lengthy. Law firms can charge up to $750 per hour for Chapter 11 bankruptcy services.

Chapter 7 Bankruptcy

Chapter 7, or “liquidation” bankruptcy, is the most straightforward and quickest bankruptcy type. It is designed for businesses that cannot continue their operations and need to liquidate their assets to pay off creditors. Both businesses and individuals can file for Chapter 7; however, it is mainly common among sole proprietorships and small enterprises.

In Chapter 7 bankruptcy, the court appoints a bankruptcy trustee who has to sell the company’s assets and distribute the proceeds to creditors according to priorities established by the Bankruptcy Code. Usually, all assets of the company are liquidated, including real estate, equipment, and intellectual property. The debtor usually takes a minimal role in these proceedings, as the trustee takes over everything.

Even though the company generally closes through this route, this type of bankruptcy is simple and fast. However, not all types of debts can be discharged through Chapter 7, such as some taxes, government-imposed fines, and fraud-related liabilities. These usually remain after the bankruptcy. Moreover, this option can also leave a long-lasting impact on business credit and future endeavors.

Chapter 13 Bankruptcy

Chapter 13 bankruptcy, or “wage earner’s plan”, allows businesses to keep their property and pay debts over time, usually three to five years. It is usually filed by individual debtors, but sole proprietors can also file for it if they want to retain ownership of their business assets and restructure their debts.

In Chapter 13, debtors must present a prepayment plan to make installments to creditors over a set time. The court must approve this plan, after which an appointed trustee will oversee the distribution of funds to creditors. Unlike Chapter 7, in which case all your assets must be liquidated, Chapter 13 lets you reorganize your financial affairs without liquidating your assets.

To qualify for Chapter 13, the debtor must meet certain debt limits. Unsecured debts must be less than $465,275, and secured debts must be less than $1,395,875. Furthermore, debtors must attend mandatory financial management courses. 

However, if you fail to adhere to the budgetary constraints and make scheduled payments according to the new plan, your business can be converted to a Chapter 7 bankruptcy.

Reasons Why Businesses Go Bankrupt

At first glance, you might think that bankruptcy is synonymous with failure. However, it can be an opportunity to strategically respond to financial issues that may challenge the business’s viability. These are the three main reasons why businesses choose to go bankrupt:

Financial Challenges

Any business might face financial challenges at some point. But commonly, these are the difficulties that lead them to bankruptcy:

Inadequate Cash Flow

A common reason for filing for bankruptcy is poor cash management. If a business spends more cash than it generates consistently over a few months, they start to struggle with operational costs. These scenarios usually arise from expensive credit terms, high overhead costs, or slow collection of accounts receivable, leading to bankruptcy.

High Levels or Inability to Repay Debt 

It’s not uncommon for companies to take loans or other types of financing either to start a business or grow their operations. But when a company takes on too much debt, it sometimes becomes unsustainable, especially if the business doesn’t generate enough revenue to cover them. Once the company isn’t able to meet its repayment deadlines or interest expenses consume too much of the company’s revenue, the company usually declares bankruptcy.

Ineffective Financial Management 

Mismanagement of financial records and poor financial decisions can also lead to an inevitable bankruptcy. If your financial director doesn’t budget wisely and doesn’t control the company’s finances, this might damage the company’s health and risk its viability.

Operational Issues

Besides financial reasons, the company may file  for bankruptcy for operational issues, too, particularly in the following cases:

Inefficient Operations

Production delays, high production costs, waste, or any other issues that hinder the company’s day-to-day operations can all lead to incompetence. These can drain resources and negatively impact the company’s competitive edge, leading to a potential bankruptcy.

Poor Management

Upper management’s decisions directly influence the performance of the business. Poor strategic choices, inadequate crisis management, lack of innovation, and failure to adapt to market changes can all lead to bankruptcy.

Loss of Staff

Losing key employees can sometimes be detrimental to the company. Imagine if the person who has access to trade secrets leaves the company; the company may find it hard to replace this person. Moreover, they might not have the capacity to hire new employees and choose to go bankrupt.

External Factors

In some cases, a business may be forced into bankruptcy, stemming from reasons outside their control. More particularly, these external factors are usually:

Market Competition

New businesses entering the market that offer lower prices or more innovative products can be challenging for existing businesses. Therefore, some businesses might find it challenging to survive in an increasingly competitive environment and decide to exit the market through bankruptcy.

Economic Downturns 

If a significant economic downturn occurs, such as a recession or a financial crisis, these can negatively impact consumer spending and tighten credit markets. Industries like real estate and luxury goods are especially susceptible to market changes, which sometimes can lead to bankruptcy.

Regulatory Changes

Certain changes in legislation or state regulation can significantly alter business operations. For instance, a new environmental law may require large technological investments to be made to meet the new standards, the company may not have the capacity to do so and have no other way but to shut down.

Natural Disasters and Global Events 

Hurricanes, earthquakes, or other global disasters can disrupt production and damage the infrastructure of several companies. With sales suspended, debts continue to accumulate, and the business is forced into bankruptcy.

What Happens When a Company Files a Bankruptcy?

The legal process for filing bankruptcy can be complex, but it varies depending on your business and the type of bankruptcy. In general, Chapter 7 is often seen as a straightforward liquidation route but can result in significant asset loss. Chapter 11, while expensive and complex, offers a way to reorganize and restart post-bankruptcy, while Chapter 13 suits individuals with regular income who can commit to a strict repayment plan.

Below, we break down the procedures associated with different types of business bankruptcies:

	Chapter 7	Chapter 11	Chapter 13
Sole Proprietorship Bankruptcy	Liquidates both personal and business assets.No need to pass the means test if your debts are primarily debt-related.Provides a clean slate but may result in the loss of all assets not protected by bankruptcy exemptions.	Allows reorganization of debts.Rarely used by sole proprietors but suitable for those with obligations exceeding Chapter 13 limits.More complex and costly even though it enables business continuity and debt restructuring.	Available to sole proprietors with regular income.Allows owners to keep their assets and pay off debts over time through a structured repayment plan.The filer can keep property that would be lost in Chapter 7.
Partnership Bankruptcy	Typically not chosen because of the risk to personal assets and the lack of debt discharge for the partnership itself.	Allows the business to operate while reorganizing debts.Can be complex and requires legal representation.	Not available.
LLC or Corporation Bankruptcy	Focuses on liquidating business assets to pay off creditors.Doesn’t erase personal guarantees.Increases the litigation risk.	Suitable for LLCs or corporations that need significant restructuring.Offers the chance to remain operational and negotiate with creditors under court oversight.Requires legal representation.	Not available.
Business Owner Bankruptcy	Erases personal debt and personal guarantees.If filed personally, offers relief and a fresh start after a business closure.	Appropriate for business owners with substantial personal and business debts.Allows to reorganize debts under a court-approved plan.Rarely used by sole proprietors but can be suitable for those whose debts exceed Chapter 13 limits.	Useful for reorganizing personal debts to help the business.Personal debts and guarantees are included, but not business debts.The business’s value is included as an unprotected asset.Can be viable if the filer doesn’t qualify for Chapter 7.

How to File Business Bankruptcies

For those thinking about how to declare bankruptcy, we’ve got you covered with all the information you need to know. Here’s a comprehensive step-by-step guide on how to file business bankruptcies:

Step 1: Credit Counseling

Before you start the bankruptcy process, you have to undergo credit counseling from an approved agency by the U.S. Trustee Program within 180 days before your petition. This session, which can be online, over the phone, or in person, is a requirement and provides an assessment of your financial situation, a review of possible alternatives, and a personal budget plan.

Step 2: Choose the Correct Type of Bankruptcy

Based on your business structure and financial situation, decide which bankruptcy chapter to file. Remember that Chapter 7 is the easiest way out but sacrifices your assets and viability, whereas Chapter 11 and 13 can help you keep your operations but are more complicated.

Step 3: Prepare and File Bankruptcy Paperwork

You then must gather and submit detailed documentation to the bankruptcy court. The list of documents you need to submit include:

• Bankruptcy petition
• Detailed list of assets and liabilities
• Snapshot of monthly income and expenses
• Statement of Financial Affairs (SOFA) for the past two years
• List of all creditors
• Executory contracts and unexpired leases
• Tax returns for the past two years
• Proof of credit counseling
• Means test forms (if applicable for Chapter 7)

Step 4: Pay Filing Fees

Filing for business bankruptcy requires you to pay a fee to process the petition. The fees include:

• $338 for Chapter 7 bankruptcy
• $1,738 for Chapter 11 bankruptcy
• $313 for Chapter 13 bankruptcy

Step 5: The Automatic Stay

Once your bankruptcy petition is filed, an automatic stay goes into effect until the bankruptcy proceedings are finalized. This prevents creditors from collecting debts or taking action against you or your business during the bankruptcy process.

Step 6: Trustee Appointment and Meeting of Creditors

After filing, the court will appoint a bankruptcy trustee to oversee your case. You will also need to attend a meeting of creditors, where they can ask questions about your financial status and the details in your bankruptcy forms.

Step 7: Compliance and Procedure Follow-Up

Depending on the type of company bankruptcy, you might need to submit additional documentation or follow specific procedures. For Chapter 7, the trustee will handle the sale of assets and distribution to creditors, but for Chapters 11 and 13, you must propose a repayment plan and gain approval from creditors and the court.

Step 8: Discharge Decree

Once all procedures are completed, and if your bankruptcy is successful, most of your business’s debts will be discharged, releasing you from personal liability for these debts.

Step 9: Final Decree

The final step is the closure of your bankruptcy case with a final decree issued by the court. This marks the end of the bankruptcy process.

Disadvantages of Business Bankruptcy 

As the old saying goes: every rose has its thorn. While bankruptcy offers a route to address overwhelming debts, it comes with several disadvantages that can prick both your business and personal life. These are some of the negative consequences:

• Long-Term Impact on Credit: Bankruptcy can tarnish your business credit rating for years to come. Chapter 7 bankruptcy remains on your credit report for 10 years, while Chapters 11 and 13 stay for seven years. This can restrict you from securing favorable financing terms in the future.

• Loss of Control and Privacy: In a Chapter 11 reorganization, your business operations and financial decisions will be under court supervision, which means reduced privacy and control. If you file under Chapter 7, the trustee will take over asset liquidation, leaving you with no say in the matter.

• Potential Loss of Property: In Chapter 7, you risk losing non-exempt business assets as they are liquidated to pay creditors. These can include tools, machinery, vehicles, furniture, real estate, as well as intellectual property like trademarks and patents. Chapter 11 might also require selling off some of these assets as part of the reorganization plan, which can potentially strip you off from your critical resources.

• Stigma and Reputation: Bankruptcy can carry a stigma that may impact your relationship with suppliers, customers, and potential investors, as they may not want to do business with someone that has bankruptcy in their history.

• Complications in Future Endeavors: Bankruptcy can complicate your ability to start new businesses in the future. You may also be restricted from obtaining certain licenses like real estate licenses and entering into some contracts.

Alternatives to Business Bankruptcy 

While bankruptcy may seem like the only refuge in some situations, it’s often viewed as a last resort because of its long-lasting impacts. Not all alternatives will work for every business, but exploring these options can sometimes provide a less drastic solution:

Debt Restructuring

Debt restructuring involves negotiating loan terms with creditors to achieve a more manageable repayment schedule. Some creditors may agree to lower the interest rates, extend the repayment deadline, or even reduce the principal amount of the debt. 

If you successfully restructure your debts, you can most likely preserve your credit score. However, this is far from guaranteed, and if you fail to reach a new agreement, you may consider filing for bankruptcy.

Out-of-Court Settlements

Another route is to negotiate directly with creditors to agree on a reduced payoff amount that is less than what is originally owed. Without the court’s involvement, this process can be faster and less expensive. 

It not only helps preserve business relationships but also provides more flexibility in terms of the settlement terms and can reduce your debt loan without the public scrutiny of a court process.

Sale of Business

And finally, the other option is to sell your business, which can be a strategic way to generate enough funds to pay off debts and avoid bankruptcy in some cases. With this option, you will lose control and ownership of your business but can protect its underlying value and ensure that creditors are paid.

The sale can be structured in various ways, including selling only non-essential assets, a partial stake in the company to raise capital, or the entire business to either a competitor or investor. This alternative is often considered when the business still holds considerable market value that can be leveraged to settle debts.

FAQ

Check out this FAQ section for more clarification:

What Is Chapter 11 Bankruptcy in Simple Terms?

Chapter 11 bankruptcy allows businesses to continue operating while restructuring their debts under court supervision. It provides the company an opportunity to realign its business strategy, renegotiate its debts, and potentially emerge financially healthier. It is primarily for businesses that believe they can become profitable again with some adjustments to their debt obligations and operational structures.

When Would Someone Be Restricted From Filing For Bankruptcy?

Restrictions can arise in several scenarios. For instance, if you have received a bankruptcy discharge in the past four to eight years, you are not eligible to claim bankruptcy within that time. 

In another scenario, a failed means test, which compares your income to your state’s median, can restrict you from filing. You will also be restricted if you have tried to defraud creditors by hiding or transferring assets prior to filing.

Does Bankruptcy Clear Tax Debt?

It can clear some tax debt, but you have to meet some criteria. To discharge income tax debt, it must be at least three years old, related to a tax return filed at least two years ago, and the tax assessment must be at least 240 days old. Taxes such as payroll taxes and fraud penalties cannot be eliminated through bankruptcy.