I’m frequently contacted by Indianapolis small business owners who’ve decided to close their doors. The owner usually says he or she wants the debt-ridden business to file a Chapter 7 bankruptcy. Is this a good idea?
As we lawyers often say, “It depends.” Here, it depends upon whether the company is a sole proprietorship or a different type of business entity.
Sole Proprietorships Versus Other Business Forms
If your company is a sole proprietorship, then you and the business are legally one and the same. An individual bankruptcy will wipe out both consumer debts and debts you incurred for the business.
On the other hand, if you’ve used a different structure, like a corporation or limited liability company (LLC), then putting the company in Chapter 7 may not be worthwhile. These types of business entities aren’t eligible to receive a discharge in Chapter 7 bankruptcy. In other words, the bankruptcy court will not issue an order that relieves the company of its debts. If there are marketable assets, the bankruptcy trustee will liquidate them and use the proceeds to pay the company’s creditors, but whatever remains unpaid will still be legally owed after the case is closed.
Even worse, if the business files a Chapter 7, the trustee may be able to assert claims against the owner of the company. For example, if the owner paid himself or herself while the business was insolvent, the trustee might sue the owner and try to recover that money for the company’s creditors.
For the above reasons, I almost always advise against filing a Chapter 7 bankruptcy for a business that isn’t a sole proprietorship. Instead, the owner should consider whether he or she would benefit from a personal bankruptcy filing. Why?
Banks and other lenders often insist upon a personal guarantee when extending credit to a corporation or an LLC. They know that if the business goes under, they’ll likely have a hard time collecting from the business itself. So they require the owner to co-sign the debt.
If the owner files an individual bankruptcy, personal guarantees will usually be discharged. The owner gets a fresh start, and the creditor must limit future collection efforts to the business itself — or what’s left of it.