Chapter 7 vs. Chapter 11 Bankruptcy: How to Choose

Individuals and businesses alike can file for Chapter 7 or Chapter 11 bankruptcy. But although it comes with heavy consequences, bankruptcy could be the lifeline you need in a financial crisis. Don’t let the unnecessary stigma of bankruptcy stop you from a fresh start.

With Chapter 7, you’ll probably lose your business, but you won’t have to pay your debt out of pocket. Under Chapter 11, you could keep your business, but you’ll need to pay at least some of what you owe with a repayment plan.

Key takeaways

• Chapter 7 is more common for individuals. That’s because Chapter 7 usually means you’ll have to sell your business, although there are exceptions to this rule. You won’t have to pay your debt out of pocket, just through the sale of assets (if you have any).
• Chapter 11 lets you keep your business, but you must repay at least some of your debt. While you’re making payments, you’ll be under court supervision and must provide monthly income and operating statements.
• Chapter 11 is much more complex and expensive than Chapter 7. If your business is very small, Chapter 11 might not make sense. There are some provisions that can make Chapter 11 more affordable for certain small businesses.

What is Chapter 7 bankruptcy?

Bankruptcy is a legal process that can help you eliminate or reduce some of your debt. Filing also gives you an automatic stay, or a pause on things like collection calls, debt lawsuits and wage garnishments. There are different types of bankruptcy, each named after its corresponding section of the United States Bankruptcy Code.

Chapter 7 bankruptcy is also known as liquidation bankruptcy. Under Chapter 7, you’ll sell eligible assets to pay off eligible debts. Any leftover eligible debt will be discharged (or forgiven).

You might think that you’ll lose everything if you file for Chapter 7, but that’s not true. Most Chapter 7 cases are no-asset cases, which means the person filing doesn’t have any eligible assets to sell. You’re allowed to keep items of daily living, such as basic clothing, necessary household items and cars (or car equity) up to a certain value.

Not everyone qualifies for Chapter 7. If your salary is above your state’s median, you’re required to pass a means test. Basically, you have to prove to the courts that you truly can’t afford to pay your debt.

For more details, please read How to File for Chapter 7 Bankruptcy.

How does Chapter 7 affect your business?

Businesses that file for Chapter 7 bankruptcy will most likely have to shut their doors. These businesses will be sold off and the proceeds will be applied to the business owner’s debt.

However, there are some exceptions:

• If your business isn’t worth a lot, you might be able to keep it since it won’t bring in much if it were to be sold.
• If you’re a sole proprietor, you may be able to exempt tools of the trade.
• If you’re a sole proprietor and run a service-oriented business (like a hairstylist or personal trainer), your business is typically safe. When you file for bankruptcy, it doesn’t affect revenue you make based off of your future labor.
• If you’re an LLC or corporation, you’ll have to exempt your shares/ownership interest to keep your business.

Generally, if you want to file bankruptcy and continue running your business, Chapter 11 is the better choice. That said, bankruptcy law is complex and we highly recommend you speak with a bankruptcy attorney.

Most attorneys give a free initial consultation. And if you earn a low or moderate income, you might qualify for free- and low-cost legal aid.

What is Chapter 11 bankruptcy?

Chapter 11 bankruptcy — or reorganization bankruptcy — lets business owners keep their doors open. That is, as long as they can get their creditors to a repayment plan, which must also be approved by the court. It’s similar to Chapter 13 bankruptcy, but creditors are more involved in the repayment planning process. Further, Chapter 13 is for people, not businesses.

When a business owner files for Chapter 11, they’ll come up with a repayment plan that’ll help them get caught up on their debt. The repayment plan could be for less than what they owe, carry a lower interest rate or have terms that make the debt easier to afford.

As long as the required creditors and bankruptcy court agree to the plan, the business can continue to operate during repayment. The business may even be able to take out new loans or lines of credit, as long as the court approves.

As the business owner follows their repayment plan, they’ll be under court supervision via a U.S. trustee. There’s no standard start or end date to Chapter 11, but it can take many years to get through. How long you’re under Chapter 11 will depend on your unique repayment plan.

Individuals can also file for Chapter 11, but this typically only happens if the person has more debt than Chapter 13 allows. To file under Chapter 13, you can’t have more than $2.75 million in secured and unsecured debts.

For more information, please read Chapter 11 Bankruptcy: How It Works and What to Know.

Chapter 11 bankruptcy and small business

Chapter 11 is one of the most complicated, lengthy and expensive forms of bankruptcy. There are two provisions that help small businesses* afford Chapter 11 — they also speed up the process.

• Small business case: To file a small business case, the business must have $3,024,725 or less in secured and unsecured debt. At least 50% of that debt must be due to business activities.
• Subchapter V: To file under Subchapter V, the business must have $7.5 million or less in secured and unsecured debt. At least 50% of that debt must be due to business activities.

*The above doesn’t apply to business owners that make money by owning and operating a single piece of real estate. These business owners (called the single asset real estate debtor) have their own bankruptcy process.

Chapter 7 vs. Chapter 11 bankruptcy: side by side

Bankruptcy alternatives

There are a ton of pros and cons to bankruptcy — it isn’t going to be the right move for everyone. Before you file, consider the following alternatives.

 Debt management plan

If you’re filing for bankruptcy as an individual (not a business), you’re required to go through credit counseling. During the process, your credit counselor might find that you’re a good candidate for a debt management plan instead of bankruptcy.

A debt management plan can help you pay off your unsecured debts in three to five years. Your credit counselor may also negotiate lower interest rates and fees with your current creditors. However, you’ll have to stop using your credit cards and you can’t open new lines of credit while working the plan.

 Debt consolidation

Debt consolidation doesn’t change the amount you owe — instead, it restructures it. When you consolidate, you’ll take out one debt consolidation loan and use it to pay off your current credit cards and eligible loans. Afterwards, you’ll have just one bill to pay (your debt consolidation loan).

Consolidating can help you save money on interest if you have excellent credit or have improved your credit score. According to a LendingTree study, personal loan rates are typically 7% lower than the average credit card rate for people with 720-plus credit scores.

There are specific lenders that offer business debt consolidation loans, too.

 Debt relief

Debt relief could help if you’re all out of options, but it comes with risk. With this, a debt relief company will try to reduce the amount you owe by negotiating with your creditors.

First, you’ll stop paying your debt bills and instead give that money to the debt relief company. Then, the debt relief company will offer it as a settlement to pay creditors. However, there’s no guarantee that your creditors will be willing to work with you or the debt relief company. Further, your credit score will likely tank, since you’ll stop making debt payments.