The Entrepreneurship – Bankruptcy Intersection

Entrepreneurs who launch their own small business are brave souls. I applaud them and share in their story. Launching into the practice of law with nothing rather than working for a salary or wages was risky. The common observation is that a substantial percentage of small businesses do not survive past the three year mark. Of those that do go beyond that milestone, some thrive and some limp along. The debt that usually accompanies a business start-up and the extent to which creditors will work with these business owners can determines these outcomes. In a sense, when a small business goes into debt, they become partners with the lender and that partner can make or break it. This is where entrepreneurship and bankruptcy intersect.

The typical scenario for entrepreneurs is that they are “all in” to birth their endeavor. They become personally obligated on the debts and usually collateralize their home and other assets. It is no surprise when small business owners blur the lines and end up identifying with their business as if it is an extension of themselves because they pour themselves into their fledling enterprise. Unfortunately, this over-identification often keeps the owners from seeing when the business has gone past the point of no return. That leads to the proverbial “good money after bad” scenario.

Compounding the dilemma for these entrepreneurs who have businesses that are failing to thrive is that the bankruptcy code only offers two options. I am not referring to Chapter 11 as an option because the business reorganization chapter of the bankruptcy code is a very expensive endeavor. Even with the changes to the code that made it easier for smaller businesses and individuals to file an 11, it is still cost prohibitive to the vast majority.

The two options are either shutting the business down and filing a personal bankruptcy, or attempting a “work-out” with the lenders. A work-out is essentially a systematic negotiation with lenders one on one to get enough relief to keep the doors open. This only happens when the lenders can see an upturn in revenue coming soon and when all the lenders are willing to cooperate. Only one lender drawing their line in the sand derails any work-out.

A personal bankruptcy can be filed in conjunction with an ongoing work-out. It might be the element that makes the lenders realize how serious the situation is so that they decide their best chance of getting paid is to cooperate. Unless the attorney in that personal bankruptcy and work-out are savvy, though, the owner could end up right back on the hook realizing no real relief from the bankruptcy.

The more likely way a personal bankruptcy plays out is coupled with the dissolution of the business. There is little to no benefit to the business entity filing a Chapter 7 because it does not receive a discharge of debt. The only time it would be beneficial is if the business has substantial assets. Then the bankruptcy allows for the controlled distribution of those assets to lenders. Usually, though, the business has few assets and so it is just dissolved prior to the filing of the personal bankruptcy.

After the bankruptcy is filed, a new business could be formed, but it needs to be done in consultation with the bankruptcy attorney. This approach is cleanest with a Chapter 7, but it can work with a Chapter 13. Usually the income of the debtor going into a bankruptcy determines whether they do a Chapter 7 or a Chapter 13, but there is a means test exception for individuals who have predominantly business related debt. So, most small business owners can do a Chapter 7. Personal debt does include one’s home loan though, and that is usually the largest personal debt weighing in against the business debt. The attorney needs to analyze the debts to insure there is more business debt than personal, and the formula used differs from circuit to circuit.

Even if you qualify for a business related Chapter 7, there may be other reasons to pursue a Chapter 13. One of the most common reasons for a Chapter 13 is when there are payroll tax arrears that end up being assessed personally to the owner. Another reason may be to cure priority income tax arrears. A Chapter 13 provides an avenue to cure these arrears over five years.