Small Business Bankruptcy: Should You File?

If COVID-19 and shutdown orders have decimated your business's income, you're probably having a lot of anxiety right now. Lots of small businesses got shut out of federal relief programs or have problems that will last longer than the relief can cover. Already, commercial bankruptcies in the first quarter of 2020 have risen 14% from a year earlier, according to data from the American Bankruptcy Institute.

Bankruptcy is indeed an option, and one that doesn't have to mean calling it quits. There's even a new way to file it that's specifically designed to help small businesses.

Two Types of Bankruptcy: Liquidation and Reorganization

But first, a quick primer. Bankruptcy comes in two basic types: a liquidation bankruptcy and a reorganization bankruptcy.

If you don't see a way to turn things around--maybe your business was already struggling before the pandemic, or perhaps it relies on large gatherings--you might choose to liquidate. That means selling all your assets to repay your creditors, and closing your business for good.

If you want to keep going, a reorganization allows you to come up with a plan to repay debt over time.

Either way, the big benefit to filing for bankruptcy is room to breathe while you liquidate or reorganize. "The instant you file for bankruptcy protection, the automatic stay puts an immediate halt to all creditor collection efforts," even those from the IRS, says Dai Rosenblum, attorney and counselor of law in Western Pennsylvania.

Here's a brief overview of the types of bankruptcy small businesses can file for and what they entail, depending on the nature and the size of your company. They are named for chapters, or sections, of Title 11 of the United States Code, the source of bankruptcy law in the U.S.: chapter 7, chapter 13, chapter 11, and subchapter V.

Chapter 7

Your small business could file for chapter 7 bankruptcy if you want to liquidate. Here's what will happen: A court-appointed trustee will inventory your business's assets, sell them, and distribute the proceeds to your creditors. The court may even put the trustee in charge of your business for a limited time if it will benefit your creditors, by generating more money to repay them.

But unlike chapter 7 bankruptcy for individuals, chapter 7 bankruptcy for small businesses does not discharge debt. What will likely happen is that creditors will seek to recover from the owners directly what they can't get out of the business.

A more typical situation is to file personal bankruptcy to eliminate the personal guarantees creditors required when you took out your business's debts. If your business is a sole proprietorship, liquidation can make sense because individual bankruptcy cases exempt certain assets from creditors' claims and discharge debts. But since only individuals can get these benefits, there is often no reason for a small business to liquidate under Chapter 7 bankruptcy, Rosenblum says.

Chapter 13

Chapter 13 is only for individuals, which means it's not an option unless your business is a sole proprietorship. That said, because it's a reorganization bankruptcy and not a liquidation bankruptcy, it could help you keep your business running. You won't have to sell assets required for business operations, and after you complete your bankruptcy plan, the court will discharge your remaining debts. This process usually takes three to five years, and it can also keep your home out of foreclosure. To qualify for chapter 13, you must have a regular income--a way to repay your debts.

Chapter 11 and Subchapter V

Chapter 11 allows individuals and businesses to reorganize and come up with a plan to repay debt instead of defaulting and going under. Chapter 11 can make sense for businesses that could become profitable again after restructuring secured debt and eliminating most unsecured debt, says San Antonio bankruptcy attorney J. Todd Malaise.

However, filing the standard chapter 11 is expensive because the creditors get to vote on whether to accept the reorganization plan, Rosenblum says. "That means a lot of negotiating. And that means a lot of lawyer time, and CPA time, and appraisers, and realtors, and liquidators."

The Small Business Reorganization Act of 2019--signed into law in August 2019 and effective February 19, 2020-- added subchapter V to chapter 11 of the bankruptcy code. This new option was only available to small businesses with debts totaling $2,725,625 million or less. Then, the pandemic happened, the president signed the CARES Act, and subchapter V became available to small businesses with debts up to $7.5 million through March 26, 2021.

Subchapter V usually allows a small business debtor to remain in possession of the business's assets and keep operating, and it doesn't require creditors' approval.

Bankruptcy Alternatives

If the downturn in your business is temporary and no one is trying to sue you, evict you, or levy your assets, you may not need to file bankruptcy at all.

To avoid paperwork, attorney fees, and filing fees, small business owners might prefer to negotiate longer repayment terms with creditors, or look for new investors or sources of credit. The company could also hire a Chief Restructuring Officer to replace existing management and turn the company around, says Ben Katz, an attorney in Frost Brown Todd's Bankruptcy and Restructuring Practice Group.

See if your creditors, vendors, and landlords will negotiate reduced payments with you. That might sound implausible, but if these people know how dire your situation is, they may prefer your proposal over getting dragged into your bankruptcy--especially now. If your landlord loses you as a tenant, who will they replace you with?

If you haven't already, stop allowing others within the company to spend money so you can keep tighter control over spending. Look for ways to scale back: reduce locations, sell equipment, furlough workers, implement pay cuts, reduce benefits, and, if you must, lay people off. If cash flow is an issue, offer a discount to those who owe you money in exchange for faster payment.

Rosenblum cautions small business owners not to become victims of the sunk cost fallacy, however. "People want to protect the sacrifices they've already made, and ignore the gains from not losing any more money," he says. "People put their hearts and souls into their businesses and can't bear the thought of losing all that sacrifice."

Filing During the Pandemic

Although many courthouses have closed due to Covid-19, they are still operating. You can complete bankruptcy paperwork electronically and meet with your attorney by phone or through video conferencing software. "Bankruptcy courts around the country are providing debtors with mechanisms for new filings," Katz says.

Bankruptcy doesn't have to mean closing your company forever, but it can also provide an orderly and official way out. Consulting with a bankruptcy attorney can help you decide what option is best for your business.