In Personal Bankruptcy, What Happens to My Small Business?

No two businesses are the same, and this diversity is echoed in the implications the personal bankruptcy of a business owner has on a small business. Nevertheless, several general points can be considered:

1. How the small business is organized
2. The chapter of bankruptcy relief sought
3. What the small business is worth
4. The nature of business operations

I will discuss each of these in turn.

How the Small Business is Organized

Small businesses organized as sole proprietorships are a special case. Unlike corporations, LLCs, and even partnerships, in a sole proprietorship, there is no distinction between the business entity and the person of the owner. So in a personal bankruptcy, the sole proprietorship business is very much in bankruptcy itself. If the business is to continue through and after the bankruptcy, questions about operations and assets become very important. I discuss these concepts more later in this article.

In other forms of organization, the business entity is distinct legally from the owner. In a personal bankruptcy, the business itself is not in bankruptcy. However, the business owner’s interest in the business (e.g. the shares of a corporation) are an asset within the personal bankruptcy. This affords some degree of isolation between the business and the owner.

In some situations, it may be possible to transition to or from a sole proprietorship prior to filing a personal bankruptcy. Qualified legal advice about any such transition is very important, as there are significant potential complications in a bankruptcy case.

What Chapter is the Personal Bankruptcy Filed Under?

In chapter 7 bankruptcy, a trustee is appointed to liquidate non-exempt assets for the benefit of creditors. For a sole proprietorship, property exemptions (a set of statutory allowances) need to be claimed if the business property is to be protected. For an entity like an LLC or corporation, exemptions generally need to be claimed in the ownership interest. If not exempt, the trustee could sell the ownership interest should a buyer be found, or exercise control over the entity if entitled to under non-bankruptcy law.

If there is liability associated with the business operations, a chapter 7 trustee might object to the continued operation of the business while the bankruptcy is pending. Such concerns are grounded either in harm to pre-filing claimants by new post-filing claims, or in possible liability of the trustee arising from the business operation.

Chapter 13 bankruptcy clearly contemplates operation of a business post-filing (see 11 USC 1304(b)). Value of the business (or its assets) still matters, as if there is non-exempt value, the chapter 13 plan must pay that value to unsecured creditors over the 3 to 5 years of the plan. However, a chapter 13 trustee cannot sell the business's property or the business ownership interest itself.

Broadly speaking, chapter 13 bankruptcy provides less risk of bankruptcy-imposed business shutdown than chapter 7 bankruptcy. However, one must have stable enough income to fund a chapter 13 plan.

What is the Small Business Worth?

How much the business is worth to someone else is an important big-picture consideration for a business-owner entering personal bankruptcy.

When ownership is structured as an LLC, corporation, or partnership, the important value is net business value. In other words, what would someone pay for the ownership of the business, or what would the owners receive if the business were shut down, paying the business's debts and selling its assets? It's important that the business's debts are accounted for, as they may be entitled to payment before an owner (or a trustee) may close the business and extract its equity. If there is no net value, a chapter 7 trustee would be unable to sell the business interest. If net value is small, the $5,000 North Carolina wild card exemption would protect the ownership interest.

For a sole proprietorship, considerations are more granular. Business debts aren’t distinct from personal debts. Similarly, business property is not distinct from personal property. Both the tools of the trade exemption and wild card exemption are frequently used to protect the business-related property. Value beyond those exemptions can create an issue in chapter 7 bankruptcy, and can make chapter 13 bankruptcy incrementally more expensive.

Nature of Business Operations

How a small business is operated can impact what happens in a personal bankruptcy. Perhaps the simplest case is a service-only business where customers pay in full at the time of service. Many consulting businesses and some professions would fit this example. All of the value of the business comes from the continued work of the business owner, and the financials are analogous to wage-type payments. Rarely does such a service-only business pose problems in a bankruptcy case.

The extreme opposite would a business with trade creditors, inventory, accounts receivable of all ages, equipment, employees, and other operational endeavors. As a sole proprietorship in chapter 7 bankruptcy, on-going operations may be very difficult. Such a sole proprietorship in chapter 13 is going to be impacted by the bankruptcy process, and care must be taken in pre-bankruptcy planning to avoid unnecessary disruption. When the same business is a corporation or LLC, careful determination of the real value of the company becomes critical.

Will personal bankruptcy help?

Small business owners certainly can find relief in personal bankruptcy. Whether business-related pressures or personal events led to the unmanageable debt, the bankruptcy process offers options for relief. For small business owners, careful and early discussion of one’s options is of great benefit for realizing optimal outcomes.