Council Post: Chapter 7 Bankruptcy For Sole Proprietors

NYC bankruptcy attorney at the Law Office of William Waldner whose sole focus is in the areas of chapter 7 and chapter 13 bankruptcy cases.

Though most lawyers and accountants recommend against sole proprietorships — and with good reason — they are far and away the most common type of small business in America, with more than 25 million sole proprietors operating a business of some kind, according to 2016 IRS data.

True, many of those might only earn a tiny fraction of their income from their sole proprietorship and may view their side hustle as more of a hobby that earns them enough to get Uncle Sam’s attention. When you file that Schedule C and you don’t have a separate business entity, you’re a sole proprietor, whether or not you think of yourself as owning or running a full-fledged business. For some, a sole proprietorship may be advantageous, but in general they’re best avoided.

But you’re an entrepreneur: a risk taker. Maybe you’ve thrown caution to the wind and grown your business from a small garage enterprise to six figures per year and you never stopped to form a separate business entity along the way. Or, maybe things just grew faster than you expected and you never got around to taking that important step.

Either way, if your business hits hard times before you’ve moved away from a sole proprietorship, you may be confronted with additional complications that legally separate business entities (and their owners) don’t have to face.

Not to worry, though. You have options, and in some circumstances your sole proprietor status may even work to your advantage.

Never make business personal…except perhaps in bankruptcy.

The major concern lawyers have with sole proprietorships is their lack of personal liability protection. Simply put, the government draws no distinction between your business’s finances and your personal finances. If you default on a personal loan, your creditor may be able to force the sale of industrial equipment you use in your business in order to recoup the loan amount. If you default on a loan you took out for that machinery, the lender can make you drain your personal savings account or possibly sell property you own (your primary residence is typically safe).

Keeping business and personal finances properly siloed means your business is safe even if you hit a bump in the road personally and ensures that you can handle business debts without worrying about your personal assets — you can even walk away from most business debts entirely, without touching a penny of personal savings.

A sole proprietorship doesn’t give you those advantages; however, if you’re facing bankruptcy, the lack of separation may, in the right circumstances, serve you well.

A Chapter 7 bankruptcy is a liquidation bankruptcy, meaning aside from certain protected assets — your home and your retirement accounts, for example — you may have to sell tangible property and deplete savings and investment accounts in order to satisfy creditors. A court-appointed bankruptcy trustee will review a schedule of your debts and assets, oversee the liquidation of nonprotected assets and distribute the proceeds to creditors who have no choice but to accept partial payment and consider your debt discharged.

For sole proprietorships with a lot of important business assets, like specialized equipment, real estate or materials used in production, a liquidation bankruptcy isn’t going to help you keep your business going. But for service providers — personal trainers, in-home chefs, accountants, nannies, etc. — you can clear out all of your existing debt and operate on a leaner basis with little trouble. This, combined with the asset protections of a Chapter 7 bankruptcy (especially the spousal protections), can make it a highly efficient way to get your debts cleared out, get your business back on track and start moving toward a new future.

Typically, if your business-related debts are higher than your personal debts, you’ll be able to file a Chapter 7 bankruptcy even with a high income — an option not available to high-earners seeking to file a purely personal bankruptcy.

What are your other bankruptcy options?

Sole proprietors may also be eligible for a Chapter 13 bankruptcy, which is a nonliquidation bankruptcy only available to individuals. This process typically takes three to five years and involves making regular payments on your debts on an extended timeline. Some of your debts may be reduced in amount as well, though typically a Chapter 7 bankruptcy represents more upfront and long-term savings.

Which option is right for you and your small business depends on your specific situation, including your family’s finances and your business operations. You’ll want to collect and organize all of your information to get a sense of the big picture and consult with your accountant and a bankruptcy lawyer in your state to determine whether bankruptcy is your best option and which type of bankruptcy you should pursue.

I’ll close with one more call to move away from sole proprietorships and into a legally separate — and liability-shielded/shielding — business entity sooner rather than later. If the cards are already on the table, though, then you’ll have to play the hand you have, and there are a few different bets you can make that may pay off.

The information provided here is not legal advice and does not purport to be a substitute for advice of counsel on any specific matter. For legal advice, you should consult with an attorney concerning your specific situation.

Forbes Business Council is the foremost growth and networking organization for business owners and leaders. Do I qualify?