The Associated Press reported that bankruptcies increased by 32% in 2009; filings in December alone were up 22% over the same period in 2008. A number of these filings are small business owners who have thrown in the towel. For some owners -- sole proprietors and usually partners -- when the business goes under so does the owner.
Surprise for sole proprietors—you must use consumer bankruptcy, even if the source of your financial woes is the failure of your business. Any business debts are treated as personal debts; there is no separate bankruptcy process for the business alone. A sole proprietor who loses his or her business can also lose personal assets, depending on the bankruptcy route. The same is true for partners in a partnership because they remain personally liable for partnership debts.
There are two types of consumer bankruptcy routes:
- Chapter 7. This is a “fresh start” process where assets (other than those exempt from bankruptcy and retained by the debtor) are liquidated and distributed to creditors. The debtor starts anew because most debts can be discharged and never have to be repaid (there are exceptions for student loans, child support, and certain other debts). The bankruptcy, however, stays on the debtor’s credit report - such as the credit reports generated by companies like Experian, freecreditscore, and Equifax - for 10 years, making it difficult in this period to obtain financing to buy a home, car, or start another business.
- Chapter 13. This is a repayment plan where current debts are paid from future income over a period of three to five years, depending on income levels. This is called a “wage earner plan.” This type of bankruptcy also goes on the debtor’s credit report for seven to 10 years.
While the fresh start route may be appealing, it is barred to anyone with a current income over a set amount. Most consumer debtors today are forced to use the wage earner plan.
Even if you have a corporation or limited liability company, you remain personally liable for certain debts after your business goes bankrupt:
- ? Bank loans you’ve personally guaranteed.
- ? Leases you’ve personally guaranteed.
Regardless of your entity choice, you cannot use bankruptcy to escape liability for payroll taxes. You continue to owe what you’ve withheld from your employees’ wages, regardless of the type of bankruptcy filing you use. You may be able to negotiate a payment plan (called an installment agreement) with the IRS to pay what you owe over time to handle this obligation.
Bottom line: If you are experiencing severe financial difficulties, be sure to consult a bankruptcy attorney as quickly as possible so you can take appropriate action and avoid missteps (such as drawing down IRAs and 401(k) plans which are exempt assets).