Types of Business Bankruptcy: Which Chapter Applies?

Chapter 7: liquidation

Chapter 7 closes the business, sells its non-exempt assets through a trustee and uses the proceeds to pay creditors. Remaining eligible business debts of a corporation or LLC are generally not pursued afterward.

A court-appointed trustee takes control of the business assets, sells them and distributes the money to creditors in a priority set by law. Corporations and LLCs do not receive a personal discharge, but they typically cease to exist, so there is no ongoing entity left to pursue.

For a sole proprietor, the business and the owner are legally the same person. The owner can receive a discharge of many debts, subject to exemptions and a means test. Debts you personally guaranteed remain your responsibility, even if the company files.

Chapter 7 fits businesses with no realistic path to profit. It is fast compared with other chapters, but it ends the business unless a buyer acquires assets from the trustee.

Chapter 11: reorganization

Chapter 11 lets a business keep operating while it proposes a court-approved plan to restructure its debts. It is flexible but can be costly and complex.

In most cases the owner stays in control as a "debtor in possession" and continues to run the business, with court oversight. The company proposes a plan that may cut debts, extend terms, sell assets or change contracts. Creditors vote on the plan, and the court must approve it.

Benefits: an automatic stay stops most collection actions, and you can reject certain leases and contracts. Drawbacks: legal and professional fees can be substantial, the process can take many months, and a failed plan may convert to Chapter 7.

Traditional Chapter 11 is usually built for larger or more complex cases. Many small companies find the Subchapter V track described next more practical.

Subchapter V: a faster path for small businesses

Subchapter V is a streamlined form of Chapter 11 for eligible small businesses, with a shorter timeline and lower cost. Eligibility depends on a debt limit that Congress has changed more than once.

Subchapter V was created to make reorganization more affordable. It typically features a trustee who helps the parties negotiate, no requirement for creditors to vote in the same way, a deadline for filing a plan and, in many cases, a way for owners to keep their ownership without paying creditors in full if they commit future income.

The eligibility debt limit has changed over time, so check the current figure with the U.S. Courts website or an attorney. Do not rely on an older article, including this one, for the number.

For a company with real customers and a viable core, but too much debt, this route deserves a serious look.

Chapter 13: for some sole proprietors

Chapter 13 lets an individual, including a sole proprietor, repay debts through a three-to-five-year plan from income, within debt limits.

Only individuals can use Chapter 13. A self-employed person with regular income may qualify if debts fall under the statutory limits. You propose a plan, make monthly payments to a trustee and keep your property, including the business, if the plan succeeds.

It can help when you want to catch up on missed payments, protect assets from foreclosure or repossession, and spread out tax debt that qualifies for payment over time. The commitment is long, and missed plan payments can lead to dismissal.

Corporations and LLCs cannot file Chapter 13. Their owners might, but only for personal debts.

What happens to the owner's personal liability

A business filing does not erase personal guarantees. If you signed one, creditors can still pursue you personally unless you also resolve that debt.

This is the point most owners miss. Many business loans and leases require a personal guarantee. If your LLC files Chapter 7, the lender may turn to you for the unpaid balance. Some owners file personally as well to deal with guarantees.

Also consider:

• Payroll taxes. Unpaid trust fund taxes can result in personal liability for responsible owners.
• Secured debts. A lender with a lien can take the collateral. See what is a lien.
• Fraudulent transfers. Moving assets to family before filing can be reversed and cause legal trouble.

Our article on business loans and bankruptcy covers how existing loans are treated.

What to try before filing

Many struggling businesses can avoid bankruptcy by negotiating with creditors, cutting costs, restructuring debt or raising working capital, if the underlying business is profitable enough to recover.

Bankruptcy is a legal tool, not a failure. Still, try these steps first, ideally with an accountant or attorney:

1. Build a 13-week cash forecast to see exactly where cash runs out.
2. Call creditors early. Many will agree to lower payments or longer terms rather than lose everything.
3. Cut costs that do not drive sales and sell idle assets.
4. Look at your debts. Read the guide to business debt and past due debt.
5. Review whether a lower-payment structure could help.

Funding is only appropriate if the business can repay it. ROI Funder looks at businesses with 6+ months in operation, $20,000+ in monthly revenue and 500+ FICO, and we show true cost and payback before you sign. Taking new debt to cover losses in a business that cannot recover only deepens the hole. Be honest with yourself and your advisor about which situation you are in.