Chapter 7 vs Chapter 11 for a Small Business: 6 Differences Owners Get Wrong

The short version: Chapter 7 liquidates your business, Chapter 11 keeps it running under a reorganization plan. Picking the wrong chapter can decide whether the business has a real chance to keep operating. Beyond these basic differences are the legal nuances you must understand to make an informed decision. The following debunks common myths to help you make a sound decision in your situation.

Whether the business keeps operating is often the main source of confusion. A Chapter 7 bankruptcy liquidates the business. That is, the trustee sells the assets of the business to pay creditors. It is the bankruptcy trustee’s job to wind down the business, not continue its daily operations. A trustee appointed to manage the liquidation in a Chapter 7 might keep the business running briefly in order to maximize the sale price, but that’s not the same as a business owner continuing to operate the business on an ongoing basis.

Chapter 11 is designed to help a business remain open. Once a business files for a Chapter 11, it becomes known as a “debtor in possession.” A trustee is rarely involved in these cases.

The Bankruptcy Discharge

Most people’s understanding of bankruptcy comes from the concept of the “fresh start” provided by the bankruptcy discharge, where most debts are wiped away. Only individuals receive discharges in a Chapter 7 bankruptcy. If the business is run as a limited liability company (LLC) or as a corporation (both of which are treated legally as separate “persons”), the debts stay with the business. Chapter 7 is still a useful choice if the goal is just to liquidate the assets in an orderly fashion under the supervision of the bankruptcy court. However, a business may get a discharge in a Chapter 11. If the plan is nothing more than a liquidation plan and the company sells off substantially all of its property and stops operating, that’s it. The company gets no discharge from its debts.

If the business has loans or other obligations guaranteed by the owners, then the owners still owe those debts in a Chapter 7. And your personal liability will not be eliminated in the business Chapter 11 bankruptcy. The best solution may require a coordinated plan, including negotiation with the lender, legal asset protection strategies, or a personal bankruptcy plan for the business owner.

If you ran your business as a sole proprietorship, you are the business, legally speaking. It doesn’t exist as a separate legal entity like an LLC or corporation. In that case, the business debts are your debts. As an individual, you may be able to use Chapter 7, Chapter 11, or Chapter 13 depending on a number of factors, including your personal income and the nature of your debts. The Chapter 7 Means Test only applies to individuals who are primarily consumer debtors and want to use Chapter 7. If your debts are primarily business debts, you are not subject to the Chapter 7 Means Test.

Stop Most Creditor Actions

Both Chapter 7 and Chapter 11 can stop most creditor actions such as repossessions and foreclosures. Many debts, including secured debt, taxes, leases, contracts, pending lawsuits, vendor claims, and more, may be able to be dealt with during the bankruptcy. Under the right circumstances, a bankruptcy plan may allow the business to renegotiate debt or sell the business as a going concern.

The ultimate question is the value of the company as a going concern compared to a liquidated company. It depends on what the assets are and how the business gets its cash flow. For some businesses, bankruptcy can preserve goodwill, customers, trained staff, contracts, licenses, and the potential for future profit. If the business has value as an ongoing concern, Chapter 11 can help reorganize for profitability. But there are cases where it just doesn’t make sense to try and save a failing business. If all of the value is in the company’s equipment, inventory, or real estate, then perhaps a Chapter 7 liquidation is the right option.

Subchapter V

Large companies can and do file Chapter 11. But they aren’t the only ones who can benefit. A small business can file a chapter 11 bankruptcy reorganization under a special procedure called Subchapter V. Subchapter V is a separate subpart of chapter 11 designed specifically to streamline the process for smaller companies. Subchapter V is available to a business with $3,424,000 or less in debt (at least half of which is from business activities). It can be especially useful for closely held companies where the majority owner wants to retain the company and continue running it.

In addition, a subchapter V small business is subject to a number of special rules. First of all, only the debtor company can file a reorganization plan, not the creditors. It must file its reorganization plan within 90 days of the petition date. Second, unless the court orders otherwise, there is no unsecured creditors committee. The goal is to keep the case simpler.

Ultimately, you want to use the right chapter for what you want to accomplish. Your best course of action depends on the nature of your business, the nature of your debts, the assets you have, and your goals. But your business may be worth keeping alive and running. In that case, give Chapter 11 (including Subchapter V) serious thought, as the goal is to fix what’s wrong with the business’s finances and allow it to be profitable again. On the other hand, if most of the value is in the hard assets, inventory, and equipment, then a Chapter 7 or possibly a simple liquidation under state law may be the more sensible alternative.