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Pros and Cons of Small Business Chapter 7 Bankruptcy

Updated: Oct 5, 2021

It happens to many small businesses: Operations and sales start slumping. While key creditors may offer forbearance agreements or even short-term extensions of credit, it’s just not enough. Perhaps the business grew too quickly for the principals to manage operational demands under an increased debt load. Maybe business never recovered from the pandemic. Perhaps the business model wrongly assumes receivables will be timely paid to keep the cash flowing as needed for debt service. Or the taxing authority has come knocking for unpaid withholding or sales taxes. Or a lawsuit naming the business as defendant has forced the principals to confront the business’s future viability considering the high costs of litigation defense, the possibility of a significant monetary judgment or repossession of critical equipment.

There are many precursors to business insolvency, with some factors beyond the control of even the most assiduous of small business owners. It’s always a difficult decision for an owner who has invested their time and personal savings into a business to wind-down operations and mitigate the consequences of unpaid debts.

Unfortunately, the closing of a small business often means the owner should file a personal bankruptcy proceeding to discharge their personal guarantees. But should the business also file a chapter 7 bankruptcy? The answer may be surprising.

Pros of Small Business Chapter 7 Bankruptcy:

  1. Preserve cash flow and company assets for the payment of trust fund taxes and other priority debts. This is particularly true in the case where the company is being pursued in litigation, state court and other actions that may result, or have already resulted, in a monetary judgment against the company. Bankruptcy stays litigation and collection on the judgment so that current cash assets and future proceeds from the chapter 7 liquidation may be applied to the payment of payroll and other trust fund taxes ahead of general unsecured creditor claims. This may also be beneficial to the company principals who can be personally assessed for those taxes.

  2. Orderly liquidation of business assets. A trustee is assigned to liquidate the remaining assets of the business and use the net proceeds after the trustee takes their cut to pay down the liabilities in order of priority. This process is especially useful if the business’s principals are unable to liquidate the business assets and there is significant inventory to be dealt with.

  3. A trustee takes over all existing operations. A trustee will immediately be assigned to manage and control the remaining operations of the business, taking the burden off the business principals and owners to terminate employees and leases, surrender collateral to secured creditors, manage bank accounts, etc. This can also be viewed as a negative consequence by some small business owners (see below).

Cons of Small Business Chapter 7 Bankruptcy:

  1. A trustee takes over all aspects of the business. A trustee will take over management and control of the business and the principals will be sidelined to simply watch and see what happens. This can be beneficial if the business is still operational and the principals no longer wish to manage the business through its winding-down, or can be viewed as a negative if the principals still have an interest in operating the business for some longer period of time and do not wish to see the business ‘go dark’ under the management of a bankruptcy trustee.

  2. No discharge of debts. Unlike a personal chapter 7 bankruptcy, there is no discharge of debts at the end of a business chapter 7 proceeding. At the end of chapter 7, the business will simply be defunct, dead in the water and typically still owing liabilities.

  3. Assets will be liquidated. Since a trustee will be liquidating the business assets, those assets are likely to be sold as quickly and cheaply as possible. This could mean a loss of equity in the assets. A fire sale by the trustee may also mean that personally guaranteed debts may not be minimized if assets are sold for less than the owner could potentially sell for herself/himself to pay down the debts.

  4. Attorney and filing fees for chapter 7 can run into the thousands of dollars.

  5. Personal exposure and risk to the business principals/owners. There is always a chance that a business chapter 7 filing will result in exposure to avoidance actions brought by the trustee against the owners and/or principals of the business. One common example is when the trustee sues a principal to recover for the benefit of the business creditors any distributions or draws taken by that principal in the one year prior to filing. For this reason, it is imperative that the business hire an experienced business bankruptcy attorney who can evaluate the risk and exposure faced by the principals/owners if the business files chapter 7 and their possible defenses. Note that if a principal is sued by the trustee, the principal must hire separate counsel since the business bankruptcy attorney cannot represent both the business and its principals.

There are other, non-bankruptcy issues surrounding the winding down of failed business enterprise which may require the services of a business attorney. Even if chapter 7 does not make sense for the business—as often it does not make sense especially for smaller businesses—the small business owner may still wish to be advised on how to resolve personally guaranteed debts, personally assessed taxes unpaid by the business, as well as how to navigate and avoid potential issues of alter ego should the owner wish to form a new business entity that is free and clear of any of the failed business’s debts.

For the small business owner that contacts my firm for assistance, I suggest the following steps:

  1. The business owner should evaluate what business debts are personally guaranteed and/or may be personally assessed. Personally owed debts may include business credit cards, leases and personally guaranteed SBA loans as well as unpaid business taxes. The answer to this may lead the owner to seek out personal bankruptcy representation.

  2. Should the owners attempt to wind down the business themselves, with or without the assistance of an attorney, or does chapter 7 bankruptcy offer any significant benefits in spite of the fact that there is no discharge of debts.

  3. Have an attorney evaluate the exposure and risk to the business owner, either in the event that a business bankruptcy is filed or under certain circumstances, for example the owner took possession and control of business assets and funds to the detriment of its creditors.

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