Last updated Oct. 31, 2018.
According to the U.S. Small Business Administration, in 2015 there were nearly 30 million small businesses operating in the United States. For various tax, legal, and financial reasons, the owners of many of these small businesses choose to operate them through a business entity, like a corporation or limited liability company (LLC).
But what happens if a small business operated as a corporation or LLC runs into financial trouble and can no longer manage its debts and expenses? For individuals, one option is to file bankruptcy under Chapter 7 of the U.S. Bankruptcy Code. By doing so, the individual can obtain a discharge of most types of unsecured debts, providing a fresh start financially.
Can a corporation or LLC do that? Sadly, no. Although business entities can file a Chapter 7 corporate bankruptcy, they cannot receive a discharge. Nonetheless, Chapter 7 can still offer some advantages to a struggling corporation or LLC. Keep reading to learn more about this important topic.
Background: A Brief Chapter 7 Overview
Before we begin discussing how business entities fare in Chapter 7, we should review the basics of the Chapter 7 process for individuals. When you file for bankruptcy under Chapter 7, the automatic stay goes into effect to stop foreclosure, repossession, and any other collection actions pending against you.
Your non-exempt assets are potentially subject to sale by the bankruptcy trustee. In theory, the trustee liquidates (sells) your assets and uses the proceeds to pay your unsecured creditors. However, in most cases, individuals who file for Chapter 7 are able to retain all of their property by using bankruptcy exemptions.
At the end of this three-to-six-month process, your remaining unsecured debts are discharged. That means you walk out of bankruptcy debt-free and can start again.
See also: Qualifying for Chapter 7 Bankruptcy in Ohio.
Bad News: Corporations and LLCs Can’t Receive a Chapter 7 Discharge
Bankruptcy procedures and rules differ for different filing parties and different types of bankruptcy. For example, Chapter 11 bankruptcy is usually reserved for large businesses that want to remain in operation, but need to reorganize their debts to do so.
In contrast, the most significant advantage of Chapter 7 bankruptcy is reserved for individuals. Although a Chapter 7 corporate bankruptcy is possible, only individuals can receive a discharge in Chapter 7 bankruptcy.
Good News: Advantages for Businesses in a Chapter 7 Corporate Bankruptcy
But just because a corporation or LLC can’t receive a discharge under Chapter 7 doesn’t mean a Chapter 7 corporate bankruptcy holds no advantages for such companies. In fact, the Chapter 7 bankruptcy process provides an orderly and transparent method for business entities to wind down their operations, sell off their assets, pay back creditors, and shut the entity down.
Although all these tasks can also be done outside of bankruptcy, doing so through Chapter 7 places a bankruptcy trustee in control of the process. Creditors may prefer to see that, because it means there is less chance that the business owner is cheating by hiding company assets instead of selling them to pay back business debts.
Bankruptcy for Small-Business Corporations or LLCs: Often Not Necessary
When many people start a business—particularly first-time small-business owners—they may choose to operate it as a sole proprietorship. In that case, the business is essentially an extension of the owner. Its assets are the owner’s assets, and its liabilities are his or her liabilities, and vice versa.
If you run a business as a sole proprietorship, you can obtain a discharge for business debts through Chapter 7, because, again, those debts are legally your debts.
That may sound like an advantage, but there are several legal disadvantages to running a business in this way.
First, creditors of your business can seek repayment out of your personal assets, not just the property you use in the business. Second, by operating as a sole proprietorship, you give up the opportunity to obtain certain tax benefits available to entities. Third, many lenders and prospective partners will prefer to deal with a corporation or LLC rather than a sole proprietor.
Consequently, many small-business owners choose to form a corporation or an LLC through which to run the business. Doing so creates a legal separation between the owner’s personal assets and liabilities and those of the business.
That means that your corporation’s or LLC’s creditors generally cannot seek repayment out of your personal assets. Instead, they must seek repayment only from the assets owned in the name of the corporation or LLC. If the business entity is terminated—even outside of bankruptcy—unpaid creditors will not normally have any recourse against you.
What if You’ve Personally Guaranteed a Business Loan?
But that’s not the end of the story. In some cases, the owner of a corporation or LLC is personally liable for the business entity’s debts. Particularly with small business entities, lenders, service providers, and others will often require that the owner of the business entity personally guarantee the entity’s debts. In that case, even if you terminate the entity, you will still be liable to pay back its creditors.
In such circumstances, the best play may be to file personal bankruptcy, then dissolve the corporate entity. Your personal Chapter 7 bankruptcy will discharge your personal guarantee, and the dissolved corporation or LLC will cease to exist.
From there, you can start over with a new entity, but your old business debts will no longer be a factor.
Of course, because this approach is quite complicated, you should work closely with an experienced bankruptcy lawyer who can help guide you through the process or offer alternative options for your consideration.
SEE ALSO: Ohio’s Homestead Exemption In Bankruptcy