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Effect of Bankruptcy on Businesses

The effect of bankruptcy can differ greatly depending on what state the business is in.  States can opt out of certain federal exemptions.  The federal exemption for equity in a home applies in all states, but different states allow for different protections of the home.  This is called the homestead protection.  Some states have an unlimited homestead exemption.  This means that creditors cannot recover from equity in a debtor’s home.  This allows debtors to put substantial amounts of money into a home in order to protect it from creditors.  Other states have a homestead exemption of $100,000 or more while other states have a homestead exemption of $5,000 or less.  This affects business, particularly small business, because most small businesses are unincorporated, which means debts are personal liabilities of the business owner.  Future earnings of a business-owner are protected.  However, business owners must surrender any current non-exempt assets.  Therefore the difference in homestead protection, based on where a business is operated, is very substantial.

Corporations, Limited Liability Corporations (LLCs), and Partnerships are individual legal entities and can file bankruptcy as an entity.  Owners of Proprietorships will be personally liable for debts and must file a bankruptcy petition individually.  Bankruptcy could force the liquidation of the entire business, sale of the business, or liquidation of the businesses assets.  If the entire business is liquidated, the business will cease to exist and the liquidation will pay the creditors.  An advantage to selling the business and using the proceeds to pay creditors is that the business will continue and the workforce will be protected under new ownership.  Liquidation of a business’s assets could give the business some time and allow a business to negotiate with creditors to work toward a reorganization of the debt.

A small corporation might entertain the possibility of liquidating the entire business and starting a new business over again.  This may be the most practical solution for a business that requires little capital and has only a few assets.

The business may file either a Chapter 7 or Chapter 11 bankruptcy.  Under Chapter 7, the assets of the business will be liquidated and the business might cease to exist if there are not enough assets to cover the debt.  Under Chapter 11, the business will file a reorganization plan to reorganize the debt.

When should a business file for bankruptcy?

As a business owner, it might be a good idea to file for bankruptcy when the business finds itself with looming credit problems that it cannot solve – when the business finds itself in a hole that it cannot climb out of.  When dealing with business bankruptcy, as opposed to bankruptcy of an individual, the benefits of bankruptcy might be more valuable than the negative effects of bankruptcy.  The negative effects can include loss of the business.  Bankruptcy of a business might not be accompanied by the shame that an individual bankruptcy might have.  This is because a business bankruptcy may prevent loss of the business.  One way the business might be saved is by reorganizing the business’s debts under Chapter 11.  A Chapter 11 bankruptcy may allow a business to receive a fresh start.

The purpose of a Chapter 11 bankruptcy for a business is to rehabilitate the business by reorganizing the business’s debts and allowing the business to pay off the debts over time.  A Chapter 11 bankruptcy does not guarantee that the business will be saved.  Sometimes, the Chapter 11 bankruptcy must be converted into a Chapter 7 bankruptcy, under which the business will be liquidated.

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