Business Debt and Bankruptcy Law

Most businesses will incur some form of debt as a necessary part of operations, whether it’s the use of credit cards or bank loans. However, problems arise when the debt load is unsustainable and out of balance with revenues, sometimes leading to bankruptcy. This section contains information and resources to help a financially troubled business, with business debts, collections, and bankruptcy.

Good Debt vs. Bad Debt

Most people are not exactly thrilled about owing people money. But there is a distinction among different kinds of debt, as some debts are held in a much better esteem than others. More to the point, “good debt” refers to debt on assets that earn your business more income than the cost of that debt. The cost of any debt is the interest charged. In contrast, “bad debt” — such as emergency loans meant to keep a business afloat during hard times — doesn’t contribute to the company’s growth and may hurt the company’s overall value.

You may have to incur some bad debt from time to time, but the key is to pay it off as quickly (and painlessly) as possible.

Prioritizing Debts: Which to Pay Off First

Deciding which debts to pay down first can be overwhelming when your company’s revenue is less than your debt obligations and monthly payments. Since you can’t satisfy all debts at the same time, it’s best to prioritize these obligations in a strategic way. For instance, certain debts must be paid in full — taxes, for instance — while other debts can be paid down gradually or even negotiated.

Your unique situation and business needs will dictate how you repay your debts, but the following debts generally should take priority (this is not a comprehensive list):

• Payroll and payroll taxes – While it may be tempting to use money withheld from employee paychecks to plug financial holes, it could lead to problems come tax time; also, you likely will face steep penalties if you fail to pay your workers on time or in full. Individuals responsible for withholding taxes may be personally liable for the unpaid taxes.

• Utilities and communications – Resources and services such as electricity, water, telephones, and Internet are absolutely critical to most businesses; and if you fall behind, you may lose these vital services.

• Loans with personal liability – Partners and sole proprietors are personally liable for business debts, although officers of corporations and LLCs also may be liable for debts they personally guaranteed.

• Court Judgments – Creditors that have won court judgments against you or your business may legally seize property or even garnish wages.

• Secured Loans – Many small business owners put up personal property, including their private home, as collateral for a loan; a default could lead to losing one’s home, or home office.

Small Business Bankruptcy

If you’re unable to secure additional funding or otherwise find yourself without options to revive your struggling business, bankruptcy may be the next option. During the bankruptcy process, the business is granted an “automatic stay” where creditors cannot collect.

Businesses that have a shot at a turnaround typically file for Chapter 11 bankruptcy protection. This allows businesses to have certain debts forgiven while they reorganize, with limited protections for the suppliers and vendors as well. But generally, the type of bankruptcy available to your business depends on your legal structure, amount (and type) of debts, plans for the future, and your personal liability for these debts.

Bankruptcy Options for Small Businesses

Chapter 7 Bankruptcy – Liquidation

Chapter 7 is the simplest type of bankruptcy available for businesses that can’t continue operating. The bankruptcy court appoints a trustee to sell or “liquidate” business assets and pay off creditors. After the bankruptcy case ends, any individual unsecured debt (such as credit cards, or supplier invoices, or rent payments) is wiped out. The business does not receive a discharge but ceases to operate. The owner is only responsible for any personal guarantees of debt.

Example: A small shoe store can’t afford to keep operating, pay rent and suppliers. The owner files for Chapter 7 to close down. A trustee sells the inventory, equipment, and any other assets to clear the business debts. After that, the company dissolves.

Chapter 11 Bankruptcy – Reorganization

Chapter 11 helps a business restructure instead of dissolve. The company is in control as a “debtor in possession” and continues to operate while creating a repayment plan for their creditors. Creditors can vote on the reorganization plan and the bankruptcy court must approve it. Unsecured creditors have a lower priority and are only paid after priority and secured claims.

The Small Business Reorganization Act of 2019 created Subchapter V of Chapter 11 bankruptcy as a way to streamline the process for small business owners with outstanding debts below a certain threshold.

Example: A fast-food chain might use Chapter 11 bankruptcy protection to reorganize debt and close unprofitable stores while continuing to serve customers.

Chapter 13 Bankruptcy – Repayment

Chapter 13 is only available for individuals or sole proprietors, not business entities such as corporations or partnerships. Chapter 13 allows business owners to keep their business and repay debts over three to five years. A bankruptcy trustee oversees this process but the owner keeps control of the property. Unsecured debts may only get a fraction of repayment as secured and priority debts get paid first.

Example: A self-employed contractor could file Chapter 13 to catch up on debts while continuing to run their business.

It is best to get legal advice from a bankruptcy lawyer to evaluate your options to help your struggling small business a fresh start. A bankruptcy attorney can also walk you through the bankruptcy code and initiate the bankruptcy filing.