Running a small business can be extremely challenging, especially when there is economic turmoil. According to the U.S. Small Business Administration, approximately 50 percent of U.S. small businesses fail within their first five years. This can be due to insufficient capital, poor credit arrangements, or having an unmanageable amount of debt. Just like individual debtors, businesses sometimes can take on too much debt or obtain credit with unfavorable terms. For a business, taking on the right amount of debt at the right time can mean the difference between a successful business and one that struggles financially.
Many lenders will only provide financing to a small business if the owner signs a personal guarantee on the debt. Providing a personal guarantee on a business debt means that if the business becomes unable to repay the debt, the individual signing the guarantee assumes personal responsibility for the remaining balance. Personal guarantees are common for small businesses, which credit issuers may view as risky. Personal guarantees are used to provide an extra level of protection to credit issuers who want to make sure that they will be repaid. However, a personal guarantee on business debt can be dischargeable if the owner files for bankruptcy individually.
Types of Small Business Debt
Seeking bankruptcy protection may be an appropriate step if a business owner has tried other options and still faces unmanageable debt. Small businesses may have many types of debt that cause them financial difficulties. These include:
A common form of unsecured revolving credit, for small business owners in particular, a business credit card can be a good way to keep business and personal expenses separated for book-keeping and tax purposes.
Lines of Credit
More like a credit card than a business loan, a small business line of credit is subject to credit review and annual renewal.
Small Business Loans
Conventional small business loans can be structured in a variety of ways, with either floating or fixed rates and monthly or quarterly payment schedules.
Merchant Cash Advances
Often used after a business is unable to obtain traditional credit, merchant cash advances are an alternate form of lending. The lender reviews the debit and credit card sales of the business and uses that to provide an advance against future sales. In exchange for an advance, the business owner provides a UCC lien against business assets including bank accounts. The merchant cash advance company will then typically take daily or weekly payments directly from the bank account of the business. This type of financing can be quite expensive with high interest rates and can often require a confession of judgment to be executed by the debtor. A confession of judgment allows the lender to forgo a lawsuit and file a judgment against the debtor upon default. Merchant advances can carry annual interest rates in the triple digits which potentially creates a difficult cycle of debt for the debtor. This type of financing also has exceedingly high default rates, which range from 20% to 30%. Often, these loans swallow up a small business owner’s account receivables and income.
This category includes leases for business premises as well as equipment and vehicle leases and may often require personal guarantees from a business owner.
Small Business Administration (SBA) Loans
Provided by the SBA, these loans include EID loans, as well as 7(a) loans, 504 loans, and SBA Microloans. SBA loans over $200,000 require a personal guarantee, although some smaller loans may also require the owner to be personally liable on the debt. Furthermore, if a sole proprietorship takes out a loan from SBA, the business owner is liable since there is no separate corporation. In this circumstance, the business and the owner are one entity for liability purposes. For some SBA loans, a business owner will have to provide a UCC lien against business assets in order to obtain a loan. This provides additional security for the SBA if the business is not successful.
Filing Bankruptcy to Resolve Business Debt
While individuals can discharge debt by filing a bankruptcy case, businesses are not entitled to a discharge of their debt in a corporate bankruptcy. However, a business owner is entitled to discharge business debt that is personally guaranteed if they file a bankruptcy petition individually. These debts might include:
- Business credit card debt
- Business loans and lines of credit
- Merchant Cash Advances
- Small Business Administration Debt
- Debts associated with leases and contracts signed by a business owner.
- Lawsuit judgments
If the business has little to no value or if they are closing their business, a debtor with personally guaranteed business debt may file for Chapter 7 or Chapter 13 bankruptcy depending upon their individual situation. In either situation, a debtor typically receives an automatic stay upon the filing of their petition which ceases all debt collection, including lawsuits, harassing debt collection calls, frozen bank accounts, garnishments, and foreclosure auctions. Chapter 7 bankruptcy allows a debtor to quickly discharge their debt and obtain a fresh start, while Chapter 13 requires a debtor to pay back the debt through a court approved 60-month payment plan. Depending upon the facts of the bankruptcy filing, sometimes a debtor just has to pay back a small percentage of the creditor’s claims that are filed in a chapter 13 bankruptcy case.
While the Chapter 7 Means Test, which often restricts higher income debtors to Chapter 13, does not apply if a majority of debt is business related, there are some situations where a debtor should choose Chapter 13 and not Chapter 7. Please note that business expenses charged on personal credit cards do not count as business debt in this calculation. First, there may be circumstances where a debtor has assets that would be non-exempt and unprotected in a Chapter 7 bankruptcy and could be subject to liquidation. In this scenario, a Chapter 13 bankruptcy filing would make sense provided the debtor has the means to pay the non-exempt value of the assets to their creditors in their Chapter 13 plan. Second, there are circumstances where a debtor may want to choose Chapter 13 bankruptcy because it allows for the repayment of debts that would not be affected by a Chapter 7 bankruptcy, such as mortgage arrears or recent tax debt. In addition, even if the debtor is exempt from the means test applying, they are also restricted to Chapter 13 if they have too much excess income in their monthly household budget.
If the business is viable or valuable, a debtor with personally guaranteed business debt may want to file for Subchapter V of Chapter 11. The Bankruptcy Code allows small business debtors to file for relief under Subchapter V of Chapter 11 and is intended to streamline various bankruptcy processes and reduce costs. When filing a Subchapter V case, the debtor must be engaged in business activities, with the exception of primarily owning or operating a single piece of real property and have combined total debts of $7,500,000 or less (including both secured and unsecured debts). Subchapter V allows small businesses to restructure their debt in order to continue operating.
Often it does not make sense for a small business to file for corporate chapter 7 bankruptcy since (1) it is much more expensive than personal bankruptcy, (2) there is no discharge issued by the Bankruptcy Court in a corporate bankruptcy filing, (3) there are often no business assets to liquidate to pay creditors, and (4) depending upon the business owners books and records, a bankruptcy filing can expose other issues such as improper preferences or transfers. In a personal bankruptcy filing, which contains business debt that was personally guaranteed, the business owner gets the benefit of discharging the business debt, allowing the owner to obtain a fresh start.
Contact The Law Offices of David I. Pankin, P.C.
If you are a business owner with personally guaranteed business debt who is struggling to keep your business afloat, you should speak with an experienced bankruptcy attorney. At the Law Offices of David I. Pankin, P.C. we have over 25 years of experience helping small business owners obtain a fresh financial start. You can contact our offices to arrange a free consultation at (888) 529-9600 or by using our easy online contact form.