Bankruptcy and Small Business: Business Debts, Owner Liabilities

This comprehensive guide explores the types of bankruptcy, implications for business debts, and owner liabilities, providing small business owners with essential knowledge to navigate financial challenges and make informed decisions.


Bankruptcy is a legal process that provides relief to individuals and businesses overwhelmed by debt. For small business owners, understanding the intricacies of bankruptcy, business debts, and owner liabilities is crucial. This guide aims to provide a comprehensive overview of these topics, focusing on the different types of bankruptcy, the implications for business debts, and the potential liabilities for business owners.

Types of Bankruptcy

Chapter 7 Bankruptcy

Chapter 7 bankruptcy, also known as liquidation bankruptcy, involves the sale of a debtor's non-exempt assets to pay off creditors. This type of bankruptcy is often used by businesses that do not have a viable path to continue operations.

  • Eligibility: To qualify for Chapter 7 bankruptcy, a business must pass the means test, which compares the business's income to the median income in its state.
  • Process: A trustee is appointed to oversee the liquidation of assets. The proceeds are distributed to creditors in accordance with the priority of claims.
  • Outcome: Once the assets are liquidated and creditors are paid, the business is typically dissolved.

For more information, visit the United States Courts Chapter 7 Bankruptcy Basics.

Chapter 11 Bankruptcy

Chapter 11 bankruptcy, also known as reorganization bankruptcy, allows businesses to restructure their debts and continue operations. This type of bankruptcy is more complex and expensive than Chapter 7 but can be beneficial for businesses with a viable future.

  • Eligibility: Any business, regardless of size, can file for Chapter 11 bankruptcy.
  • Process: The business submits a reorganization plan to the court, which must be approved by creditors and the court. The plan outlines how the business will repay its debts while continuing operations.
  • Outcome: If the reorganization plan is successful, the business can emerge from bankruptcy with a more manageable debt structure.

For more information, visit the United States Courts Chapter 11 Bankruptcy Basics.

Chapter 13 Bankruptcy

Chapter 13 bankruptcy is primarily designed for individuals but can be used by sole proprietors. It involves creating a repayment plan to pay off debts over three to five years.

  • Eligibility: Sole proprietors with regular income can file for Chapter 13 bankruptcy.
  • Process: The debtor proposes a repayment plan, which must be approved by the court. The plan allows the debtor to keep their assets while making payments to creditors.
  • Outcome: If the debtor completes the repayment plan, remaining eligible debts may be discharged.

For more information, visit the United States Courts Chapter 13 Bankruptcy Basics.

Business Debts in Bankruptcy

Secured vs. Unsecured Debts

  • Secured Debts: These are debts backed by collateral, such as a mortgage or car loan. In bankruptcy, secured creditors have a higher priority and may reclaim the collateral if the debt is not paid.
  • Unsecured Debts: These are debts not backed by collateral, such as credit card debt and medical bills. Unsecured creditors are paid after secured creditors and may receive only a portion of what they are owed.

Priority of Claims

In bankruptcy, debts are paid according to a priority system established by the Bankruptcy Code. The order of priority is as follows:

  1. Administrative Expenses: Costs associated with the bankruptcy process, including trustee fees and legal expenses.
  2. Secured Claims: Debts backed by collateral.
  3. Priority Unsecured Claims: Certain unsecured debts, such as employee wages and taxes, have priority over other unsecured claims.
  4. General Unsecured Claims: Remaining unsecured debts.

Discharge of Debts

A discharge releases the debtor from personal liability for certain debts, meaning they are no longer legally required to pay them. The scope of discharge varies depending on the type of bankruptcy filed.

  • Chapter 7: Most unsecured debts are discharged, but certain debts, such as taxes and student loans, may not be.
  • Chapter 11: Debts are restructured, and the business continues to pay according to the reorganization plan.
  • Chapter 13: Debts included in the repayment plan are discharged upon successful completion of the plan.

For more information, visit the Internal Revenue Service Declaring Bankruptcy.

Owner Liabilities in Bankruptcy

Sole Proprietorships

In a sole proprietorship, the business and the owner are legally the same entity. This means the owner's personal assets are at risk in bankruptcy.

  • Personal Liability: The owner is personally liable for all business debts. If the business files for bankruptcy, creditors can pursue the owner's personal assets.
  • Bankruptcy Options: Sole proprietors can file for Chapter 7, Chapter 11, or Chapter 13 bankruptcy, depending on their circumstances.


In a partnership, the partners share liability for business debts. The extent of liability depends on the type of partnership.

  • General Partnerships: All partners are personally liable for business debts. Creditors can pursue the personal assets of any partner.
  • Limited Partnerships: Only general partners are personally liable. Limited partners' liability is limited to their investment in the business.

Corporations and Limited Liability Companies (LLCs)

Corporations and LLCs are separate legal entities from their owners, providing limited liability protection.

  • Personal Liability: Owners (shareholders or members) are generally not personally liable for business debts. Their liability is limited to their investment in the business.
  • Piercing the Corporate Veil: In certain circumstances, courts may hold owners personally liable if they have commingled personal and business assets, committed fraud, or failed to follow corporate formalities.

For more information, visit the U.S. Small Business Administration Choose a Business Structure.

Special Considerations for Small Businesses

Impact on Credit

Filing for bankruptcy can have a significant impact on a business's credit rating, making it more difficult to obtain financing in the future. However, it can also provide a fresh start by eliminating overwhelming debt.

Tax Implications

Bankruptcy can have various tax implications, including the treatment of canceled debt as taxable income and the potential loss of tax attributes, such as net operating losses.

For more information, visit the IRS Chapter 7 Bankruptcy – Liquidation Under the Bankruptcy Code.

Employee Considerations

Bankruptcy can affect employees, particularly in terms of unpaid wages and benefits. In Chapter 11 bankruptcy, businesses must continue to meet payroll obligations and may need to renegotiate labor contracts.

Navigating bankruptcy requires legal and professional assistance. Business owners should consult with bankruptcy attorneys and financial advisors to understand their options and develop a strategy.


Bankruptcy can be a complex and challenging process for small business owners. Understanding the different types of bankruptcy, the implications for business debts, and the potential liabilities for owners is essential. By seeking professional advice and carefully considering their options, business owners can make informed decisions and work towards a fresh financial start.

For more information and resources, visit the following official links:

This guide aims to provide a comprehensive overview of bankruptcy and its implications for small businesses. By understanding the legal framework and seeking appropriate assistance, business owners can navigate the challenges of bankruptcy and work towards a more stable financial future.

About the author
Von Wooding, Esq.

Von Wooding, Esq.

Lawyer and Founder

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