A Chapter 7 bankruptcy for a sole proprietorship is really a personal bankruptcy, because in California a sole proprietor and the business are the same legal person. Business and household debts go into one case, the business usually stops operating, and the owner can receive a discharge of most of what they owe, while exemptions protect key personal property.
If you are deciding whether to close your doors, call (415) 754-0115 to schedule your free consultation, or send a message through our contact page before you take on new credit or sell off equipment.
Why a sole proprietor cannot file "for the business"
Corporations and LLCs are separate entities, so they can file their own bankruptcy, as our article on whether an LLC can file Chapter 7 explains. A sole proprietorship has no separate existence. The fictitious business name on your storefront, your business bank account and your seller's permit all belong to you personally.
That has two consequences. First, every business debt is already your personal debt, whether it is a supplier invoice, a business credit card, an equipment lease or a commercial lease. Second, there is no way to file only for the business while leaving your personal finances out. The case covers everything you own and owe.
How Chapter 7 bankruptcy for a sole proprietorship works
The mechanics follow a normal individual Chapter 7, with a few business-specific steps.
The means test may not apply
The Chapter 7 means test applies when a filer's debts are primarily consumer debts. Many sole proprietors who are closing up owe mostly business debts, such as trade creditors, business loans and leases. When non-consumer debts make up the larger share, the means test generally does not apply, which can open the door to Chapter 7 even with a recent history of strong business income.
The trustee and business assets
When you file, a Chapter 7 trustee is appointed to review your assets. Inventory, receivables, equipment, vehicles and money in the business account are all part of the estate. Anything you can protect with a California exemption stays with you. Unprotected assets may be sold and the proceeds paid to creditors. In practice, many small service businesses have little the trustee can sell.
Tools of the trade
California's exemption systems include protection for tools, equipment and a vehicle used in your trade or profession, within limits. Choosing between System 1 and System 2 is one of the most important decisions in a sole proprietor's case, because the right choice depends on whether you own a home, how much equipment you have and what you plan to do next.
Operating during the case
A Chapter 7 trustee can technically keep a business running, but that is rare for a small sole proprietorship. In most cases the business winds down before or at filing. Owners who want to keep operating usually look at Chapter 13 instead.
Debts that survive the discharge
Most business debts, including supplier balances, business credit cards, unpaid rent on a closed location and many loan balances, can be discharged. Some cannot:
- Trust fund taxes. Sales tax collected from customers and payroll taxes withheld from employees' wages are generally not dischargeable.
- Recent income taxes, including self-employment tax, typically survive.
- Debts tied to fraud or false financial statements can be challenged by creditors.
Unpaid employee wages within certain limits are priority claims, which matters to your former staff. If tax debt is the main problem, our page on small business tax debt help covers IRS options that may work alongside bankruptcy.
Closing up the right way before you file
How you wind down can affect the case. Bankruptcy trustees review the months and years before filing, and certain steps can create problems:
- Paying back a relative or friend who lent the business money within the year before filing may be recoverable by the trustee as a preference.
- Selling equipment below value or giving it away may be undone as a fraudulent transfer.
- Running up new credit to keep the doors open in the final weeks can invite challenges to discharge.
- Losing records. Keep tax returns, bank statements, profit-and-loss reports and inventory lists. The trustee will ask for them.
Talking with an attorney before the closing sale or the final payroll often makes the difference between a smooth case and a complicated one.
Chapter 7, Chapter 13 or a negotiated exit
Chapter 7 suits owners who are done with the business and need a fresh start. Chapter 13 for a sole proprietor may fit an owner who wants to keep operating, protect a home with significant equity or pay priority taxes over time. Some owners avoid bankruptcy entirely by negotiating with a handful of large creditors.
The Somal Law Firm advises individuals and small business owners across Pleasanton, Dublin, Livermore, San Ramon and Alameda and Contra Costa Counties on Chapter 7, Chapter 13, debt settlement and IRS disputes. Because the firm handles bankruptcy, creditor negotiations and tax matters, attorney Bob Somal can compare all three routes against your actual numbers rather than steering you toward one.
Frequently asked questions
Can I start a new business after Chapter 7?
Yes. Nothing in Chapter 7 bars you from starting over, and many owners go on to freelance, take a job or open a new venture. Income earned after filing generally belongs to you.
Do I have to list business debts and personal debts together?
Yes. As a sole proprietor you must list all debts, business and personal, on one set of schedules. Leaving creditors off can create problems with the discharge.
What happens to my commercial lease?
An unexpired lease can be rejected in bankruptcy, and the unpaid rent and damages become a claim that is typically discharged. Because you signed the lease personally, there is no separate business entity to leave it with, so it is handled in the same case.
Will I lose my work truck?
Not necessarily. Vehicle and tools-of-the-trade exemptions may protect it, depending on its value and any loan against it.
If your sole proprietorship is closing under a pile of debt, call (415) 754-0115 to schedule your free consultation with The Somal Law Firm, or reach us through our contact page. Bring recent tax returns and a list of business creditors, and we will map out how a Chapter 7 case would look for you.
Attorney Advertising. This article is general legal information for Bay Area residents, not legal advice, and does not create an attorney–client relationship. Every situation is different — please consult a licensed attorney about your specific circumstances.