Business Bankruptcy: Chapter 7 vs. Chapter 11 for Companies

Bankruptcy is a federal legal process that provides businesses (and individuals) with protection from creditors and, depending on the chapter, either an orderly process for winding down or a mechanism for restructuring debt and emerging as a viable going concern. For business owners facing financial distress, understanding the available bankruptcy options — and the alternatives to them — is essential to making informed decisions before options run out. The stigma around bankruptcy often causes business owners to wait too long, when earlier action would have preserved more options.

The Automatic Stay

One of the most immediately valuable features of any bankruptcy filing is the automatic stay. Upon the filing of a bankruptcy petition, an automatic stay goes into effect that immediately halts virtually all collection actions against the debtor and its property: lawsuits, foreclosures, repossessions, bank levies, wage garnishments, and creditor harassment. The automatic stay buys the debtor time — to assess the situation, negotiate with creditors, and formulate a plan without the pressure of immediate collection actions. For a business owner facing imminent foreclosure or a judgment execution, the automatic stay can be the difference between having enough time to restructure and losing the business in a chaotic forced sale.

Chapter 7: Liquidation

Chapter 7 bankruptcy is a liquidation process. For business entities — corporations and LLCs — Chapter 7 results in the appointment of a bankruptcy trustee who takes control of the business’s assets, liquidates them, distributes the proceeds to creditors in the priority order established by the bankruptcy code, and dissolves the business. After the liquidation, the corporate or LLC entity ceases to exist.

An important point for business owners is that Chapter 7 for a corporation or LLC does not discharge the business’s debts in the way that Chapter 7 for an individual does. Because the entity is being dissolved rather than reorganized, the discharge is irrelevant — the entity simply ceases to exist after the liquidation, and unpaid creditors receive whatever the liquidation proceeds allow, with nothing further. Personal guarantees given by the owners survive the business’s bankruptcy, and owners who have guaranteed business debts remain personally liable for them.

Chapter 11: Reorganization

Chapter 11 bankruptcy is a reorganization process that allows the debtor business — typically remaining in control as a ‘debtor in possession’ — to propose a plan of reorganization that restructures its debts and allows the business to continue operating. The debtor has an exclusive period (initially 120 days for most cases) to file a plan of reorganization, which must be approved by creditors and confirmed by the bankruptcy court.

A Chapter 11 plan can accomplish a wide range of restructuring objectives: reducing the principal amount of secured debts to the collateral value, extending payment terms on debts, rejecting burdensome leases and executory contracts, converting unsecured debt to equity, and obtaining new financing from existing or new lenders. The flexibility of Chapter 11 is its greatest strength, but it comes with significant cost: attorney and professional fees in a Chapter 11 case are substantial, and the process is time-consuming. For most small businesses, the costs of traditional Chapter 11 were prohibitive.

Subchapter V: Small Business Reorganization

The Small Business Reorganization Act of 2019 added Subchapter V to Chapter 11, creating a significantly streamlined and less expensive reorganization process for small businesses. To qualify for Subchapter V, a debtor must have total debt (both secured and unsecured) below a threshold that has been adjusted over time (currently set at $7.5 million, subject to further adjustment).

Subchapter V offers several advantages over traditional Chapter 11: a trustee is appointed to facilitate the reorganization (but the debtor remains in control of the business), no creditors’ committee is formed (saving significant cost), the debtor can confirm a plan of reorganization over creditor objection if the plan commits all of the debtor’s ‘projected disposable income’ to repaying creditors over a 3 to 5 year period, and there is no requirement to pay unsecured creditors in full if the plan is fair and equitable. For many small businesses, Subchapter V has made reorganization financially accessible when traditional Chapter 11 was not.

Alternatives to Bankruptcy

Bankruptcy is not the only option for businesses in financial distress, and for some businesses it is not the best option. Out-of-court restructuring — negotiating directly with creditors to modify debt terms, extend payment schedules, or accept less than full payment in exchange for certainty — avoids the public nature of bankruptcy, preserves confidentiality, and is less costly than court proceedings. Asset sales or wind-downs outside of bankruptcy can also be appropriate in some circumstances. Whether bankruptcy or an alternative makes more sense depends on the number and type of creditors, the nature of the assets, the business’s ongoing viability, and whether the automatic stay protection is needed.

Timing Matters

One of the most consistent findings among business bankruptcy practitioners is that clients who seek advice early have substantially more options than those who wait until the situation is desperate. An attorney can help evaluate all available options, including negotiated restructuring, Subchapter V reorganization, and traditional Chapter 11 or Chapter 7, and can help preserve assets and maximize recovery for the business and its owners. By the time a forced sale or judgment execution is imminent, many options have already been foreclosed.

The Bottom Line

Bankruptcy is a sophisticated federal legal process with significant strategic implications for businesses in financial distress. The introduction of Subchapter V has made reorganization a realistic option for small and medium-sized businesses that previously had no practical alternative to liquidation. Business owners facing financial challenges should consult with a bankruptcy attorney early — not just to understand the bankruptcy process, but to explore whether restructuring can preserve a business that would otherwise be lost.