Starting a small business entails significant risk. You forego the security of a steady paycheck to create economic opportunities for yourself. Business failure rates have remained steady over the years, but the statistics are pretty daunting: by the five-year mark, around half of small businesses have failed.
While the reasons for small business failure vary, it almost always comes down to financial woes. When a company is no longer able to pay its debts, the US Bankruptcy Code may offer help by enabling it to either discharge its debt in an orderly fashion or reorganize its debt while continuing to operate.
The word “bankruptcy” is one that some business owners have come to fear. In reality, though, bankruptcy can actually help an entrepreneur regain control of their distressed company and enjoy a financial fresh start.
Small Business Bankruptcy Trends
Approximately twenty thousand to twenty-five thousand businesses file for bankruptcy each year in the United States, according to the Administrative Office of the US Courts. The number of business bankruptcy filings has steadily decreased over time, even during the COVID-19 pandemic, although filings have started to creep back up in 2022.
Experts expect that with the end of government aid programs that helped keep businesses afloat amid the pandemic, more businesses will seek debt relief via bankruptcy. Currently, businesses are facing a variety of challenges that could make a bankruptcy filing more likely, including higher interest rates, rising inflation, worker shortages, and supply chain issues.
During the twelve-month period ending June 30, 2021, there were a total of 18,511 business bankruptcy filings. The majority (10,466) were Chapter 7 filings, followed by Chapter 11 (6,375), and Chapter 13 (982). In the first quarter of 2022, commercial bankruptcy filings were down 25 percent from last year, according to legal research firm Epiq.
Reasons for Small Business Bankruptcy
Small business owners are probably familiar with the high failure rates that they are up against: about one in five new businesses fail within the first year; roughly one in two do not survive the five-year mark; and after ten years, only around one-third of small businesses are still around.
But why do small businesses fail? Specific reasons for small business bankruptcy include the following:
- Poor planning
- Business conditions, such as increased competition and higher costs
- Management mistakes
- Trade credit problems
- Loss of clients
- Tax problems
- Creditor disputes (e.g., foreclosures, lawsuits, and contract disputes)
- Personal issues (g., illness and divorce)
- Calamities, including fraud, theft, accidents, and natural disasters
In addition, Insureon, an online marketplace for small business insurance, says that most small businesses lack insurance policies that could pay for lawsuits and other incidents that frequently lead to bankruptcy.
Bankruptcy Options for Small Businesses
There are six types, or chapters, of bankruptcy in the US Bankruptcy Code: Chapter 7, Chapter 9, Chapter 11, Chapter 12, Chapter 13, and Chapter 15. Of these, Chapter 7, Chapter 11, and Chapter 13 are most commonly utilized by businesses or business owners.
Chapter 7 Bankruptcy
Chapter 7 bankruptcy, also known as liquidation bankruptcy, is the most common—and most straightforward—form of bankruptcy in the United States. This type of filing forces you to turn over all nonexempt assets—both personal and business—to the court for liquidation (i.e., sale). The proceeds are then divided among creditors.
For sole proprietors, the debt that remains after this process wraps up is typically dischargeable, with some exceptions, including alimony and certain tax obligations. For corporations, partnerships, and LLCs, the debts that remain after liquidation are not dischargeable. However, practically speaking, there will be no company to collect from after one of these entities files for Chapter 7, as it closes the business (Remember that in companies that provide personal liability protection, creditors cannot go after the personal assets of owners.)
Chapter 7 does not necessarily close a sole proprietorship. Since many sole proprietors who are service providers do not have much in the way of assets, they may be able to keep the basic tools of their trade as exempt assets while holding onto their most important asset—themselves (the business owner who provides the service). Their future services cannot be liquidated.
Chapter 11 Bankruptcy
Chapter 11 bankruptcy is an option that allows businesses—sole proprietors, partnerships, corporations, and LLCs—to keep their business and reorganize their debt. This is an option for owners who want to maintain control of business operations, avoid selling their assets, and emerge from bankruptcy with a healthy business.
To start the process, the business files a petition with the court. The business must then propose a reorganization plan within 120 days. The plan explains how debt will be restructured and how creditors will be repaid. For example, the business may attempt to change the terms of their debts by obtaining lower interest rates and an extended payment plan. All creditors must endorse the plan before the court will approve it.
The Chapter 11 debt reorganization process can be complex, lengthy, and expensive. And there is no guarantee that the reorganization plan will be approved—or that the business will be profitable subsequent to its bankruptcy. It will need to make enough money to satisfy the renegotiated debt payments.
Small businesses may choose to file under two special categories of Chapter 11: a small business case and subchapter 5. As part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, Congress increased the small business debt limit for subchapter 5 cases from $2,725,625 to $7,500,000. The temporary increase in the subchapter 5 debt limit expired on March 27, 2022, but Congress is considering making the change permanent.
Chapter 13 Bankruptcy
Chapter 13 is another type of reorganization bankruptcy available only to individuals, including sole proprietor business owners. Businesses such as corporations and LLCs are not eligible to file for Chapter 13, which works similarly to Chapter 11 but has smaller debt limits.
An additional limitation to keep in mind is that Chapter 13 repayment plans, if approved, are subject to a three-to-five year limit. If you satisfy your debt obligations throughout that period and make it to the end of the plan, you can expect most of your unsecured debt to be discharged. But your business will need to make enough money during this period to support the repayment plan. All your disposable income may be required to go toward the plan, which means you could be living pretty lean during the repayment period.
Unlike Chapter 11, in which a trustee can be avoided, a bankruptcy trustee is always appointed in a Chapter 13 action. The business distributes money to the trustee, who makes payments to creditors on a priority basis.
A Chapter 13 filing is usually cheaper and simpler than a Chapter 11 filing and allows you to discharge more types of debt. But if running your business depends on expensive equipment that does not fall within an exemption—and you are not making enough to repay your creditors and keep the equipment—Chapter 13 probably will not work for you.