Thought Leadership  •  October 26, 2022

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What Is Bankruptcy? Pre-Planning, Filing Requirements & Business Strategies

Many bankruptcy resources focus on the consumer side of debt relief. However, the process of declaring a business bankrupt has some important differences from consumer bankruptcy. Brush up on the 3 types of bankruptcies a business may declare and learn how to decide when bankruptcy may be the best decision for your business.

What Is Bankruptcy?

This question is tricky to answer because there are multiple types of bankruptcies a business can file, and they differ in key ways. In some types of bankruptcy, a business can keep important assets, pay off debts and eventually recover to be in better shape than before. This sounds optimistic, but consider that businesses including Kmart, Chrysler and even Marvel Entertainment have all been through bankruptcy and remain vital to the economy.

We'll get into the types of business bankruptcy later. For now, let's review the basics. What does bankruptcy mean, and how did it become law?

From a legal point of view, bankruptcy reflects a state of being bankrupt. This means that an individual or business has debts they are unable to pay. The process of bankruptcy allows an individual or a business to alleviate the debt burden while repaying a portion of what is owed through a structured process overseen by the courts.

Bankruptcy filings date back to the 1800s in the US. The process was officially formalized by Congress in the Bankruptcy Act of 1898. That act has been reformed several times and was replaced in 1978 by what is known as the Bankruptcy Reform Act. Cases of bankruptcy today still follow procedures outlined in the 1978 law.

Is Bankruptcy Right for Your Business?

While no one goes into business hoping to declare bankruptcy, sometimes things fall apart. How can your business tell if bankruptcy is, while not desired, your best next move?

Businesses have cycles or seasons. While things ebb and flow, if things haven't been going well for some time, debts can accrue. If you're running out of money, or don't see a way to repay debts, you may be considering filing for bankruptcy.

In some cases, entrepreneurs are grateful for the bankruptcy process because their hearts are no longer in the business. Winding down one business to reinvent themselves in another niche can be attractive.

In other cases, a business has taken on too many debts and cannot make the minimum payments as required. Bankruptcies that include debt restructuring, or negotiating better repayment terms, can help the business through stressful situations, including economic recessions.

Ultimately, bankruptcy can be a tool to provide a business owner with a fresh start. That might be in another business or another industry, or it might provide a bridge for a struggling business when taking out another loan does not make sense — especially if the owner cannot identify a revenue stream that would allow the loan to be paid off in the future.

When it comes to bankruptcy and debt restructuring trends, business health does seem to be a bright spot. Overall filings have fallen since a high in 2010, coming out of the Great Recession.

Types of Bankruptcy for Business

Learning more about the 3 types of bankruptcy can help you determine which, if any, make sense for you:

Chapter 7: Liquidation

Chapter 7 bankruptcy is known as liquidation. The business ceases operation and goes out of business. An entity sells off (or liquidates) assets and the proceeds are used to pay down debts. This type of bankruptcy allows the owner to get out of debts, but it completely erases the business and its assets. There is no bouncing back from a Chapter 7, there is only moving forward.

One note on assets here: Business owners who listed a personal asset as collateral when taking out a loan may be forced to liquidate this asset during the bankruptcy proceedings. So, if you listed your house as collateral to secure a bank loan, you may be forced to sell it.

Chapter 11: Reorganization

In this form of bankruptcy, debts are reorganized. This is what you'd choose if you'd like to keep the business operating when all is said and done. The goal of a Chapter 11 bankruptcy is to give the business time to sort out financial issues, improve its operational health and restructure debt that has become unaffordable.

Businesses may choose this option if they've tried renegotiating the terms of their debt to no avail. With the shield of bankruptcy to protect the business, creditors who held out previously may now be forced to negotiate.

Chapter 13: Personal Bankruptcy

This type of bankruptcy is only available to individuals. However, if your business is structured as a sole proprietorship, you may wish to file under Chapter 13 rather than a business type of bankruptcy.

Chapter 13 tends to be faster and cost less than Chapter 11, making it attractive. It also allows a sole proprietor to keep some personal assets that a Chapter 7 bankruptcy would require they sell.

Pros & Cons of Filing for Bankruptcy

Bankruptcy planning is never fun, but there may be times when there is an advantage to it. For one, it can preserve valuable assets that would otherwise be lost. Bankruptcy can also be an exit plan to a new career.

There are some downsides to explore with the assistance of a pre-bankruptcy planning legal consult:

• Not all types of debt can be discharged through bankruptcy. • Your credit score is affected for up to 10 years. • Repayment terms can stretch on for 20 years under a Chapter 11 or 5 years under a Chapter 13. • Bankruptcy is time-consuming and emotionally draining. • There are limits to how much debt can be discharged.

Requirements for Filing

Given the complexities of the bankruptcy process, we strongly encourage retention of a lawyer after reviewing this bankruptcy guide. To help with business planning, however, here are the requirements for filing each type of bankruptcy:

Chapter 7:

You'll need to open a petition with the bankruptcy court closest to the business's place of operation and provide:

  • Current assets and debts
  • Current income and expenses
  • Business contracts and leases
  • The most recent tax return
  • Other financial statements as needed

Chapter 11

While the process differs, the filing requirements are the same as for Chapter 7.

Chapter 13

To qualify for Chapter 13, the business must be a sole proprietorship with debts not to exceed $2,750,000.

The business owner must file the above-mentioned financial documents as well as:

  • A credit counseling certificate
  • A monthly net income statement
  • Evidence of employment payment, such as equity from the business
  • Debt repayment plans developed in the credit counseling process

Regardless of which process you choose, the paperwork can be overwhelming. For a business, it can help to use AI-powered bankruptcy management software to seek out and gather necessary reports instead of having to assign an employee to sort through business records by hand.

Ultimately, bankruptcy strategies can help a business evolve while allowing creditors some measure of relief. With a better understanding of the different types of bankruptcy and requirements for filing, your business can analyze the situation and make the right choice.