For a small business in financial distress, bankruptcy may be the only viable option. There are two restructuring options under bankruptcy law for debtors who want to try to stay in business: Chapter 11 and Chapter 13. For a “straight” or “liquidation” bankruptcy: Chapter 7.
To some extent, Chapters 11 and 13 are similar. Both types of bankruptcy allow debtors to continue in business and propose plans to restructure their finances. Subject to legal requirements and limitations, a Chapter 11 or 13 plan can:
- Allow you to retain property needed to operate your business.
- Give you time to sell assets you no longer need or cannot afford to keep.
- Modify payment terms on secured debts (like automobile or equipment loans).
- Discharge (or in other words, eliminate) obligations that you cannot pay over the plan term.
Most small business owners, when possible, choose Chapter 13 over Chapter 11. Chapter 11 can provide more flexibility, but it usually costs substantially more than Chapter 13.
Eligibility for Chapter 11 or Chapter 13 Bankruptcy
Virtually anyone can file for Chapter 11 bankruptcy, whereas small businesses that operate as a corporation or LLC are ineligible to file for Chapter 13.
Chapter 13 Eligibility
Chapter 13 is available only to individuals with regular income. If you operate your business as a sole proprietorship, you can take advantage of Chapter 13 by filing a petition on your own behalf. Otherwise, Chapter 13 is not an option you can choose. Small businesses operated through corporations, partnerships, or other entities are not eligible to seek Chapter 13 relief.
Chapter 13 is also subject to debt limitations, which change periodically. Currently, eligibility for Chapter 13 is limited to individuals who owe no more than $383,175 in unsecured debt and $1,149,525 in secured debt. Unsecured debts are obligations that are not backed by collateral, such as medical bills and credit card claims. Examples of secured debts are home mortgages and car loans. Individuals cannot file for relief under Chapter 13 if they owe more than the specified debt limits.
Chapter 11 Eligibility
On the other hand, almost anyone can file bankruptcy under Chapter 11. Individuals, corporations, partnerships, joint ventures, and limited liability companies are all eligible to be Chapter 11 debtors. There are no debt or income requirements or limitations for filing bankruptcy under Chapter 11.
Appointment of a Trustee
Whether a bankruptcy trustee will be appointed in your case differs in Chapter 11 and Chapter 13 bankruptcy. In Chapter 11, appointment of a trustee is the exception rather than the rule. The bankruptcy court may appoint a Chapter 11 trustee, but only if there is cause, such as gross mismanagement, or fraud.
In Chapter 13, a trustee is always appointed. Chapter 13 trustees review the proposed plan and other documents and make recommendations to the bankruptcy court on how to proceed. Chapter 13 trustees are also responsible for collecting plan payments and distributing the proceeds to creditors. If you fail to make required plan payments, the Chapter 13 trustee (or creditors) can ask the court to dismiss the case.
Chapter 11 Proceedings: Pros and Cons
A big disadvantage to Chapter 11 is that the proceedings can be complex and expensive. However, there are special provisions which streamline and expedite Chapter 11 cases involving “small business debtors.”
For these purposes a “small business debtor” is a person or entity who:
- Is engaged in business or other commercial activities.
- Owes no more than $2,490,925 in total debt (excluding obligations owed to insiders such as family members of the business owner).
An advantage of Chapter 11, if you can meet all of the statutory requirements, is that there is no set limit on a plan’s duration. Chapter 11 plans typically provide for debtors to make payments to creditors over a period of three to five years. The bankruptcy court can confirm a Chapter 11 plan with a longer term, however, if you need more time to make required payments. Small business debtors with real property mortgages or equipment loans, for example, often need extended payment terms.
Chapter 13 Proceedings: Pros and Cons
The plan approval process tends to proceed much more quickly in Chapter 13 than in Chapter 11.
Chapter 13 plans usually have a “commitment period,” or duration, of three to five years. During the commitment period, the debtor must turn over all of his or her “disposable income” to the Chapter 13 trustee for distribution to creditors. A debtor’s “disposable income” is the difference between his or her monthly earnings and the amount “reasonable necessary” for his or her maintenance and support.
The commitment period in Chapter 13 cases can be shortened if all unsecured creditors are paid in full. Under no circumstances, however, can a Chapter 13 plan be extended longer than five years. This can make it difficult or impossible to confirm a Chapter 13 plan in cases where the debtor owes significant secured debt that must be paid to retain assets needed to continue in business.
“Disposable Income” in Chapter 11 Cases
Unlike Chapter 13, Chapter 11 does not require individual debtors to turn over their “disposable income” to a trustee. The total value of the debtor’s plan payments, however, must equal at least the amount of his or her “disposable income” over a five-year period.
More Types of Debts Are Dischargeable in Chapter 13 Than in Chapter 11
One of the primary reasons debtors file bankruptcy is to discharge obligations that they owe to creditors. Most debts can be discharged in bankruptcy, but there are exceptions. There are more exceptions to discharge under Chapter 11 than Chapter 13.
A key difference between the two chapters relates to divorce obligations. Support obligations for the care or maintenance of a child or spouse cannot be discharged under Chapter 11 or 13. Nonsupport obligations, on the other hand, can be discharged — but only in Chapter 13. Payments due on account of a property settlement, for example, may be considered a nonsupport obligation that can be discharged through a Chapter 13 plan.