Bankruptcy is a legal status where a company is unable to pay its debts and seeks relief from its creditors, often resulting in the liquidation of assets or a reorganization to address its financial difficulties.
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Last Updated: December 15, 2025
Sometimes small business owners find it necessary to file for bankruptcy. While it’s never a fun step, it can be a necessary one. This guide will explain what bankruptcy is, including the different types, how it works, and more.
Bankruptcy is a federal court process designed to relieve individuals and businesses from unpaid debt. When a business files bankruptcy, it exchanges its assets for a “discharge,” or erasure of debt. In turn, its creditors receive an equitable portion of the business assets, according to a set priority and list of exceptions.
Small businesses have options when filing for bankruptcy. Business owners can use bankruptcy to liquidate or stay in business and reorganize. The chapter a business files under will determine its responsibilities before it can receive a discharge.
If a business owner needs to close their small business, they may benefit from liquidation through Chapter 7 bankruptcy. In Chapter 7, a bankruptcy trustee collects the company’s assets, sells them, and distributes the proceeds to creditors. When a business files under Chapter 7 as a corporation, partnership, or limited liability company, the business is considered an entity separate from its owners. The owner’s assets are protected from the business debts and cannot be used in bankruptcy. Sole proprietors do not have limited liability protection; those business owners will have both their consumer and business assets considered.
One of the advantages of bankruptcy is that a company can remain in business and take time to repay its debts. The Bankruptcy Code calls this a “reorganization.” The business submits a plan to repay a portion of its debts over a specified period. A bankruptcy attorney can advise business owners on the specific requirements for their plans.
Business owners may reorganize under Chapter 11 or 13, depending on whether they formed a legal entity for their business. Reorganizing a sole proprietorship requires the business owner to file under Chapter 13 because the owner’s identity is the same as that of the business. A corporation, limited liability company, or partnership must file under Chapter 11.
A new business owner might have to take on all kinds of debt to get started. For example, a restaurant might need to buy equipment on credit. Often, the seller will require the business owner to secure the loan’s value using the equipment as collateral. The holder of a loan requiring collateral is a “secured” creditor. Other loans are “unsecured” creditors because they do not have collateral, like some bank loans and most taxes. Between secured and unsecured creditors, the secured creditor has priority over the business assets. The business owners are considered “equity security holders” and are paid last.
Bankruptcy stays on a person’s credit report. For an LLC or corporation, a bankruptcy could stay on its credit report for up to 10 years, limiting its access to capital. However, business bankruptcy can affect the owner’s personal credit only if the business is a sole proprietorship or the owners signed a personal guarantee for the business debt. In that case, the business creditors might access the owner’s personal assets, and any outstanding balance might harm their credit.
After learning the definition of bankruptcy, a business owner might decide that bankruptcy isn’t the right path. There are other options, though. Examples of bankruptcy alternatives include:
Bankruptcy is only one method businesses use to overcome overwhelming financial obligations.
Bankruptcy is a formal method for a failing business to pay off creditors and receive a discharge of remaining debts. If a business needs to liquidate or reorganize, bankruptcy might be the right choice.
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Disclaimer: The content on this page is for information purposes only and does not constitute legal, tax, or accounting advice. For specific questions about any of these topics, seek the counsel of a licensed professional.
Written by ZenBusiness Editorial Team
The ZenBusiness Editorial Team has more than 20 years of combined small business publishing experience and has helped over 850,000 entrepreneurs launch and grow their companies. The team’s writers and business formation experts are dedicated to providing accurate, practical, and trustworthy guidance so business owners can make confident decisions.
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