Bankruptcy: When All Else Fails
The goal of a bankruptcy is to give honest debtors a "fresh start" by discharging or negotiating debt. Even so, economic analysts advise owners of troubled companies to consider alternative plans, such as debt consolidation and remediation, in order to solve financial strain. Still, when all else fails, bankruptcy is a viable solution when carefully considered.
Simply put, bankruptcy is a federal or state court proceeding in which an insolvent individual or company is relieved of some or all debt liability. In these cases, the person or corporation is too deep in debt to repay. Bankruptcy protects individuals and businesses by structuring a plan to pay debtors over time, or in the case of unsecured debt credit card debt for instance to eliminate that debt.
The court also prevents debt collection agencies from using harassment tactics like late night, threatening telephone calls or contact with vendors and clients. In fact, all collection efforts cease when the company or owner files for bankruptcy protection in a state or federal court.
The Federal Rules of Bankruptcy Procedure, or "Bankruptcy Rules," govern the bankruptcy process. There are also state laws enforced by individual state bankruptcy courts. The Bankruptcy Code and Bankruptcy Rules describe the legal procedures for solving debt problems of individuals and businesses.
Given the complexity and significance of a bankruptcy filing, business and financial experts advise hiring a legal firm that specializes in bankruptcy-related matters such as satisfying contracts, loans, long-term leases, payroll and other business-related debt. Attorneys also use courts to release clients from certain debtor obligations.
Before declaring bankruptcy, the business or sole proprietor should note that there are costs involved in filing, including court and attorney fees. In addition, certain debt will still be owed regardless of a bankruptcy filing. Debt that is not eliminated includes: taxes, student loans, debts resulting from fraud or willful injury, child support and alimony. Some property settlements, fines and penalties are also exempt from bankruptcy protection.
The sections that follow summarize the three types of bankruptcy most often used by small businesses.
Chapter 7 Bankruptcy
Chapter 7 is the most common form of bankruptcy protection. It’s sometimes called a straight bankruptcy. With a Chapter 7 filing, the business owner relinquishes all non-exempt property to a court-appointed, bankruptcy trustee, who in turn converts property in to cash to pay creditors. With a Chapter 7 filing, business operations cease and the company is dissolved.
Federal law dictates that some debtor property is subject to liens and mortgages pledging the property to creditors. Exempt properties vary from state to state, but typically include homes, cars, apparel, household appliances, life insurance, pensions and work-related tools.
The court-appointed trustee is empowered to take legal action to collect money payable to the debtor, or to the bankruptcy estate. From start to finish, the Chapter 7 process usually takes between four to six months. This time period varies, though, depending on the complexity of the case
To be eligible for Chapter 7, a business owner must undergo mandated credit counseling from an approved agency within 180 days before filing, so plan ahead. Upon meeting this requirement, the debtor is no longer liable for debts eliminated by the bankruptcy judge. However, with Chapter 7 bankruptcies, only sole owners are eligible for protection. Partnerships or corporations are not eligible for Chapter 7 protection.
Chapter 11 Bankruptcy
Chapter 11 bankruptcy is designed primarily for businesses in financial trouble, but not prepared to close down. Eligible companies include corporations, sole proprietorships and partnerships.
Designed to allow organizations “breathing room” to continue operations while repaying creditors through a court-approved plan, Chapter 11 bankruptcy restructures and eliminates certain debts. The objective of a Chapter 11 bankruptcy is to develop a multi-level reorganization plan to sustain the company while the owner repays creditors over time.
Under this Chapter 11 protection, a corporation does not place the personal property of stockholders in jeopardy because a business is considered a separate, legal entity from its owners. Conversely, sole proprietorships filing Chapter 11 do place both business and personal assets at risk an important consideration when choosing the right type of bankruptcy for your circumstances. Like a corporation, a partnership is also a separate entity, but with a Chapter 11 bankruptcy filing, it’s not uncommon for the partners’ personal assets to be used to pay off creditors.
In all cases, the bankruptcy court reviews relevant documentation, such as contracts and leases, to create an appropriate payment plan. The court also develops a plan to liquefy company assets to pay creditors another important consideration.
Federal law mandates that individuals seeking Chapter 11 protection must go through credit counseling from an approved agency either in an individual or group session within 180 days before filing. Debt management plans devised during this required counseling phase are filed with the bankruptcy court.
In emergency situations, a company owner may receive an exemption from the required counseling.
Chapter 13 Bankruptcy
Chapter 13 bankruptcy laws provide for debt adjustment in the case of an individual with regular income. Also called a "wage earner’s plan," a Chapter 13 filing allows filing workers to develop a strategy to repay all or part of their debt.
Under Chapter 13 protection, debtors make installment payments to creditors over three to five years. During this period, the law forbids creditors from implementing or continuing collection efforts. Chapter 13 also offers some distinct advantages over Chapter 7, which requires complete liquidation. Under Chapter 13 protection:
- individuals may save their homes from foreclosure.
- secured debts (other than a mortgage on a primary residence) may be rescheduled and restructured, thus lowering monthly payments.
- third parties, liable with the debtor on "consumer debts" (i.e. loan co-signers), also receive court protection.
- Chapter 13 operates like a consolidation loan. The debtor makes payments to the court trustee who then distributes payments to creditors.
Any individual, even when self-employed or operating an unincorporated business, is eligible to file for Chapter 13 protection, provided the unsecured debt is less than $336,900, and secured debt is no more than $1,010,650 (adjusted periodically).
A corporation or partnership is not eligible for Chapter 13 protection, nor is a person who’s had a prior bankruptcy petition dismissed due to noncompliance with court orders. As with Chapter 7 and 11 bankruptcies, petitioners must undergo counseling from an approved agency within 180 days prior to filing.
Choosing to file for bankruptcy and selecting the right type of bankruptcy should be discussed with a bankruptcy attorney and your business’ accounting firm. It should also be considered a last resort because a bankruptcy stays on your credit record for seven years. Sometimes longer.
So get the expert advice you need before undertaking this life-altering event and make sure you’re protected under the full extent of state and federal bankruptcy law.
It’s the smart thing to do in a tough situation.