When It Is (And Isn’t) the Right Time to File for Bankruptcy

Business.com / Financial Solutions / Last Modified: July 31, 2017
Photo credit: Billion Photos/Shutterstock

For owners of struggling businesses, bankruptcy can seem frightening. However, there are several options, including avoiding bankruptcy altogether, if you're dealing with mounting debt.

When you started your business, you had big goals in mind. Maybe you hoped that your venture would quickly lead to long days lounging on the beach. But now things aren't going as planned. And the last thing you have time for right now is a stroll on the beach.

If your business is failing, don't be too hard on yourself. After all, according to the Bureau of Labor Statistics, only 50 percent of businesses make it past their fifth year. While filing for bankruptcy can seem scary, you have several options, including possibly avoiding bankruptcy altogether.

Bankruptcy is a legal proceeding that occurs when a company or individual can't repay outstanding debts. It’s important to consider alternatives before filing for bankruptcy (it's a final option when you have no other way out). That being said, here's what you need to know if and when it is time to file for bankruptcy.

What's your business structure?

If you have a sole proprietorship or general partnership, the choice is quite simple: You most likely should file for Chapter 7 or 13 bankruptcy if there's no way out of debt.

As the Small Business Administration (SBA) says, a sole proprietorship is an "unincorporated business owned and run by one individual with no distinction between the business and the owner." A general partnership assumes that both profits and liability are divided amongst the partners. With both business types, you're personally liable for your business obligations, like debt and judgments.

If you have a limited liability company (LLC), or S corporation, you can possibly avoid bankruptcy if alternative options, like refinancing, are available. This is because an LLC typically protects members' personal assets in the event of failure, with the exception of loans and funding that come with a personal guarantee. S corporations function similarly from a legal standpoint.

As the owner of an LLC or S corporation, understand the business is responsible for the debts it incurs. If you truly believe your company won't be able to get out of debt, your options are either a Chapter 7 or Chapter 11 bankruptcy.

The same goes for a corporation. A corporation, or C corporation, is an independent legal entity owned by shareholders. This means that the corporation itself, not the shareholders, is held legally responsible for any debts the business incurs. The two main forms of bankruptcy for a corporation are Chapter 11 and 7 – the former being the first choice for most companies.

Under Chapter 11, a company can develop a plan to settle its debt obligations. If the Chapter 11 fails or there is no hope of continuing as a viable business, a corporation will likely file a Chapter 7 bankruptcy – a complete liquidation of assets.

Are alternatives to bankruptcy a viable option for your business?

Bankruptcy should be thought of as a last resort. Not only will bankruptcy damage your credit and potentially your credibility as a businessperson, but legal fees and court costs are steep.

If you're drowning in debt, the good news is that filing for bankruptcy isn't necessarily the only way to go. You should first prioritize the debts and then consider alternatives. Often, there are better routes to take.

Depending on your situation, some options instead of bankruptcy include:

  • Taking steps to reduce debt: From collecting debts owed to you to selling off unneeded assets to increasing revenue, you can chop down debt to make it more manageable and keep your business running. Explore every option; don't incur more debt, and cut back on business expenses. 

  • Negotiating directly with creditors: Be honest. Describe your hardships. Some creditors will understand and be open to a payment plan. When it comes down to it, many creditors are willing to work with you because they want their money back (which won't happen if you file for bankruptcy). 

  • Refinancing your debt: It could be that a high APR is ballooning your debt. Or perhaps longer loan terms would help. Explore your options with lenders to see if you can't make your loans cheaper. Refinancing is a good option if market interest rates are lower.

  • Consolidating your loans: This is a great way to manage (and limit) business debt. Debt consolidation is the process of taking out a single loan to pay off all existing loans, allowing for one consistent payment and possibly lowering interest payments. Debt consolidation can also give you more time to repay what you owe.

These alternatives are only options if you can repay the money owed. Don't kick the can down the road with expensive refinancing or debt consolidation. Make sure the alternative makes financial sense for your business and your professional and personal goals. If you're just delaying the inevitable with more debt, bankruptcy may a better option.

Corporations have similar options, again, only if the business is viable for long-term operation. A corporation can negotiate outside of court to work out a plan to pay its debts – similar to a Chapter 11. If an out-of-court settlement isn't an option, the corporation could look into an "assignment for the benefit of creditors," or ABC, which is similar to a Chapter 7 bankruptcy but enables a business to sell its assets itself. ABCs, however, come under state law, so the rules vary depending on the state.

Note: If you run an LLC, you have another simple option: Just end the operation. You're not personally liable if you've properly separated business expenses from personal ones and don't have any loans with personal guarantees outstanding.

As Michael J. Duffy, a specialist in bankruptcy and business law, says, "If only a limited liability business entity were suffering financial trouble, the best thing to do is just close the doors and walk away." This is because the only recourse creditors have is against the business.

Which type of bankruptcy is right for your business?

If bankruptcy is your only viable solution, consider the different types of bankruptcies and which one is most suitable for your business.

Chapter 7 bankruptcy

Liquidation is suitable for all types of businesses. Basically, all assets are sold and the money is repaid to creditors. Then, you close the doors. It will hurt your credit, but Chapter 7 bankruptcy is a straightforward way to move on from the situation if debt is overwhelming.

Chapter 11 bankruptcy

Restructuring company debt to allow more time for repayment is suitable for LLCs and corporations. Your creditors decide on an appropriate repayment plan, which must be approved by the court. While this can be costly and complex, a Chapter 11 bankruptcy does keep you in business. If time is what you need, this may be the best option.

Restructuring company debt to allow more time for repayment is suitable for LLCs and corporations. Your creditors decide on an appropriate repayment plan, which must be approved by the court. While this can be costly and complex, a Chapter 11 bankruptcy does keep you in business. If time is what you need, this may be the best option.

Chapter 13 bankruptcy

Designed for personal bankruptcy, a Chapter 13 bankruptcy is for businesses that are not separate legal entities, like a sole proprietorship or general partnership. With this type of bankruptcy, a repayment plan is agreed upon with creditors. You repay all or a portion of your liabilities, depending on your income. This can let you wipe out certain unsecured personal debts, such as credit card balances. But creditors can still go after assets if you don't repay.

Dealing with bankruptcy successfully

Keep your business structure in mind as you explore ways to get out of mounting debt. Second, explore alternatives by crunching the numbers and seeing if certain solutions are even possible. If you can refinance or consolidate your debt, analyze whether you can handle those payments and continue to run your business successfully. If alternatives aren't an option or are financially unfeasible, it may be time to declare bankruptcy.

If you decide to file for bankruptcy, you still have ways to get your business back on track. Even if you've decided to close the doors, you still have the opportunity to try again. In the end, remember that the game isn't over. Success is still achievable. And you can enjoy long walks on the beach when it's all over.

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