Chapter 7 Bankruptcy: A Fresh Start
Updated: Jul 15
By Tsu-Li Liew
With COVID-19 hitting businesses hard across the country, many owners are closing their small businesses down. Some even consider whether bankruptcy is the right choice for them. After making the decision to declare bankruptcy, a business owner needs to pick which type of bankruptcy will suit their needs, whether that is an asset liquidation or a business restructuring. In this article, we explore the basics of Chapter 7 and how it may help a small business owner with their debt.
Chapter 7 is one type of bankruptcy that a qualified individual or business can file for, usually as a last resort to manage debt. The business owner’s case will be assigned to a court-appointed trustee who will start the process of asset liquidation. Asset liquidation means that assets will be sold, and the money from the sale will be used to pay off any debts that the owner may have. Some assets that are necessary to life, such as clothing and household items, will be exempt from the sale. Any debts that are not paid off in full might be discharged by this proceeding, and the owner will then free from these debts.
Not everyone can file for Chapter 7 bankruptcy. If a business owner wants to file for bankruptcy, they must first pass the “means test” by filing out a 122A-2 Form. More information on the means test can be found at the Department of Justice. The test determines if the owner needs financial assistance by comparing their average income over the past six months to the average income of a similar household. If the business owner’s average income is below the average income of a similar household, they will be eligible for Chapter 7 bankruptcy. Chapter 7 does not take into account how much debt a business owner has, or whether they have or do not have the money to pay the debts back. After all, a Chapter 7 filing is meant to give the individual a fresh start. If a business owner decides that they want to restructure the business, they are able to switch to a different bankruptcy chapter, such as Chapter 11 or Chapter 13. The only problem with that is that an owner is only allowed one switch during each proceeding. Therefore, if they had switched into Chapter 7 from another bankruptcy chapter, they are restricted from switching to a different chapter again.
There are other requirements and restrictions that may prevent a business owner from filing as well. A business owner will need to have received credit counseling from an approved credit counseling agency six months before filing the bankruptcy petition. However, there are two exceptions to this: 1) emergency situations and 2) insufficient approved agencies in the area. If a business owner does not fall into the two exceptions, then they are required to seek credit counseling before they can move on with the process.
A business owner may be barred from filing a petition if they have done so in the past six months and have either failed to appear before court or failed to comply with court orders, which automatically dismisses the case. This applies if the business owner voluntarily dismissed the case as well. A business owner also cannot file another petition if they had a Chapter 7 bankruptcy discharge within the past eight years.
Once a business owner passes the means test and had received credit counseling, then they finally can file a petition with the bankruptcy court in the area where they live or where the business is located or organized. Along with the petition, a business owner will also have to file: 1) schedules of assets and liabilities, 2) a schedule of current income and expenditures, 3) a statement of financial affairs, and 4) a schedule of executory contracts and unexpired leases. The owner will need to provide: 1) a list of all creditors and amounts owed, 2) the source of their income, 3) a list of all property, and 4) a list of living expenses. The courts will charge a fee for filing, but a business owner can pay up to four installments or apply for a fee waiver. The waiver will depend on a business owner’s economic status. Once the petition has been filed along with the other documents, then an automatic stay prevents certain creditors from collecting their debts or any wage garnishments. The stay also prevents creditors from foreclosing on an owner’s property.
A court-appointed trustee will be assigned to the case, who will review the assets and schedule a meeting within 60 days between the business owner and their creditors. During this meeting, creditors will be able to address questions to the trustee and owner. After the first meeting, the creditors will then have 90 days to file a claim in order to be considered for money. However, if a governmental unit was a creditor, they have 180 days to file a claim instead. If the owner has any assets, an estate will be created for the bankruptcy proceedings.
The trustee will sell any nonexempt assets to raise money for this estate, which will pay the business owner’s debt. Nonexempt assets include secondary property, secondary vehicles, collectibles or bank accounts of a business owner. The SBA provides a guide on liquidating assets here. Then, the money will be paid off to creditors. The creditors who have a security interest in property used as a collateral will have priority over those who do not.
Even if there are debts remaining, the business owner will usually be discharged from the debts, and creditors will not be able to bring collection actions against the owner. However, certain liabilities will continue, such as alimony, child support and student loan debt. The courts will also decide which debts will be discharged.
Also, while both individuals and businesses can file for Chapter 7 bankruptcy, debt discharges only apply to individuals or sole proprietorships and not to businesses that are formed as partnerships or corporations. Individual owners of a partnership who filed a Chapter 7 bankruptcy petition for the business might still be personally liable for the debts that remain. U.S. Courts and Investopedia have more information on Chapter 7 bankruptcy.
Advantages and Disadvantages
While an owner could just shut down a business without resorting to bankruptcy, there are some advantages to filing a bankruptcy petition. Especially during COVID-19 shelter-in-place orders where many non-essential businesses are not operating at full capacity or at all, any generated income may not be enough to pay back overhead costs, such as rent, utilities and other expenses. If the owner files for Chapter 7 bankruptcy, the creditors will be prevented from trying to get their money at that moment. This will give the owner some breathing room, while they sort out their finances with an attorney, a credit counselor and/or their court-appointment trustee. A Chapter 7 bankruptcy proceeding has a relatively quick turnaround, which can be resolved within a year.
Another advantage of Chapter 7 bankruptcy is that after paying out the money earned from selling assets, the owner is no longer liable for any of the debts that remain. This means that owners are off the hook for the debt they incurred from running their business that they were not able to pay off, even when their assets were sold. Any creditor who tries to collect on these debts could be fined, unless they formed an agreement with the owner to “reaffirm” the debt. Therefore, it is important that the business owner keeps the bankruptcy documents as evidence, in case such a creditor tries to make a claim some time later.
While these advantages provide relief for small business owners, there are many disadvantages that appear during the process and can follow them even years later. Filing for a Chapter 7 bankruptcy can only be done every 8 years, and a business owner would be restricted from filing within those 8 years. This means that an owner will have to be careful with the timing, making sure that they will eliminate any risk of having to file a petition within that time period. Otherwise, an owner will not be able to have their debts discharged and will have to pay back all their creditors.
Many business owners also file for bankruptcy as a last resort, usually when they are in a situation trying to prevent taking on more debt than they already have. Filing for a Chapter 7 bankruptcy will also be the end of the business, since all the assets will be sold to pay off any debts. Therefore, a business owner needs to be very certain about their decision when it comes to Chapter 7, as the business will be dissolved once the proceedings are done.
Oftentimes, many Chapter 7 cases do not have any assets to liquidate either, which means the owner did not have any nonexempt assets to liquidate. Filing for bankruptcy also damages an individual’s credit score, which may prevent them from taking out loans or starting new ventures in the future. Even if an owner can get out of one business through bankruptcy, they might have a harder time getting a fresh start if they are locked out of opportunities that require lots of funding.
Whether a debt is discharged will also depend on the good behavior of the business owner. A discharge can be denied if the owner failed to keep adequate books or financial records or failed to explain the loss of any assets. Any criminal acts, such as perjury, fraud or disobeying court orders, can prevent debts from being discharged as well. A business owner’s actions prior to the bankruptcy proceedings will also determine the outcome. If the creditor files a claim in time, debts that were obtained by the owner with false pretenses or fraud will not be discharged either.
A Chapter 7 bankruptcy petition is also only good for individuals or sole proprietors, as debt discharges are not extended to partnerships or corporations. This limits who will benefit from the advantages of Chapter 7 bankruptcy, since partnerships and corporations will still have to pay off their creditors even after all the assets have been sold and the business stops to exist. Many businesses might be better off filing for a different chapter, such as Chapter 11 or Chapter 13. The New York Times and the U.S. Securities and Exchange Commission have written about the differences between Chapter 7 and Chapter 11 bankruptcies. Ultimately, it will depend on what the business owner wants to do after the bankruptcy proceedings.
Filing for bankruptcy is often a choice that a business owner makes when all other methods have been exhausted. Chapter 7 bankruptcy allows an owner to close the business while paying off the debts they increased and shield them later from any leftover debts that were not covered. While the goal is to give business owners a fresh start, the damage on their credit score and a higher risk might prevent or delay it from happening.
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