Bankruptcy Definition

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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Sometimes small business owners find it necessary to file bankruptcy. If you’re searching for a bankruptcy definition that makes sense, our team of business experts are here to outline the various types of bankruptcy and the disadvantages.

What is bankruptcy?

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. 

What happens during bankruptcy?

Small businesses have options when filing bankruptcy. Business owners can use bankruptcy to liquidate or stay in business and reorganize. The chapter you file under will determine your responsibilities before you can receive a discharge.

What are the benefits of chapter 7 bankruptcy?

If you need to close your small business, you may benefit from liquidation through chapter 7 bankruptcy. In chapter 7, a bankruptcy trustee collects the company’s assets, sells them, and distributes the value to creditors. When you file 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. If you are a sole proprietor, you do not have limited liability. Your consumer and business assets will be considered.

What happens in chapter 11 or chapter 13 bankruptcy?

One of the advantages of bankruptcy is that you can remain in business and take time to repay your debts. The Bankruptcy Code calls this a “reorganization.” You will submit a plan to repay a portion of your debts over a period of time. A bankruptcy attorney can advise you on the specific requirements for your plan. 

You may reorganize under chapter 11 or 13, depending on whether you formed a legal entity for your business. To reorganize a sole proprietorship, you will 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. If you need to form a legal entity, our Business Formation Services can help you through the process.

An additional bankruptcy business definition: What is a creditor?

When you start a business, you might need to take on different kinds of debt. 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 to the business assets. The business owners are considered “equity security holders” and are paid last.

Bankruptcy Considerations

Bankruptcy stays on your 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 your personal assets, and any outstanding balance might harm your credit.

What are alternatives to bankruptcy?

After learning the definition of bankruptcy, you might conclude that bankruptcy isn’t for you. You have other options. Examples of bankruptcy alternatives include:

  • Negotiating a debt settlement directly with creditors;
  • Selling unnecessary property or assets;
  • Reducing non-essential spending;
  • Slowing growth or reducing production;
  • Making debt repayments a top priority; and
  • Seeking guidance from your financial or legal advisors. 

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 your business needs to liquidate or reorganize, bankruptcy might be the right choice for you.

We Can Help

We know the challenges you face as a business owner. We want you to achieve your dreams. Let us handle the details while you keep your focus on running your business. We designed all of our products and services to guide small business owners through their legal requirements.

Disclaimer: The content on this page is for information purposes only and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.

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Written by Team ZenBusiness

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