Insights Into Small Business Bankruptcies

Many U.S. businesses filed for bankruptcy last year. Through the end of the third quarter of 2024 (the latest available statistics at this writing), formal bankruptcy filings were on track to exceed the 2023 mark and the watershed year of 2020. Here's a look at what's driving the increase and how the process works, including revised rules for small businesses that went into effect in 2022.

A Perfect Storm

As of September 30, 2024, 512 U.S. companies had filed for bankruptcy in calendar year 2024. This is higher than year-to-date filings reported in the third quarter of 2023 (504) and perilously close to 2020's year-end total (518). (That peak was generally attributed to fallout from the COVID-19 pandemic.)

Why are bankruptcies on the upswing? Rising inflation, higher interest rates, low consumer confidence and geopolitical uncertainty are contributing factors. Also, adverse market conditions may cause a small business to experience:

Decreased demand. Customer preferences may change, causing a shift in the marketplace or the need for goods or services can dry up. More sophisticated, nimble competitors might be better positioned to adjust offerings or prices to accommodate these changes or may use advanced analytics to take market share from unwary small businesses.

Cash flow shortages. Small businesses can run into trouble when outgoing expenditures exceed incoming revenue. Shortfalls may happen when companies grow rapidly. But lax working capital management—for example, bloated inventory, late customer payments and bad debts—is often a precursor to bankruptcy.

Ineffective debt management. Business owners may borrow money to stay afloat during a cash crunch. However, interest payments and other related problems can drain a company's resources and eventually sink it.

Poor leadership. Successful businesses have qualified, experienced managers in key roles. Without professional management, small businesses can struggle and fail to implement corrective measures.

In addition, small businesses may have difficulty recovering from online scams, cyberattacks and embezzlement schemes. Larger companies generally have greater resources to absorb fraud losses and respond appropriately.

Bankruptcy Basics

Bankruptcy is a formal legal proceeding initiated when a business can't meet its legal obligations. It offers a "fresh start" when a business is no longer viable.

Chapter 11 of the U.S. Bankruptcy Code mainly allows a distressed business to reorganize its debt. After the filing is complete, the business continues to operate. This option may be preferable to Chapter 7 or Chapter 13. With Chapter 7, assets are liquidated, so creditors typically receive little or nothing. Chapter 13 is only available to wage-earners, self-employed individuals or sole proprietors. Among other differences, Chapter 13 has higher income thresholds than the other options, but you must pay off secured debts like car loans and mortgages in full.

Close-Up on Chapter 11

Chapter 11 filings are most prevalent, in part, because there's no income limit and they're flexible. Typically, these proceedings involve debt restructuring—including priority tax debts, secured debts, contract debts and unsecured debts and leases —while offering protection of business assets.

The process starts when a debtor business voluntarily petitions the bankruptcy court or when creditors file an involuntary petition against the debtor after certain conditions have been met. In either situation, the business typically has about four months to develop its reorganization plan. However, the court may extend that timeline to up to 18 months if the debtor can show "just cause" for a delay.

A bankruptcy judge makes several important determinations, including whether a debtor is eligible to file and will be discharged of its debts. Courts also appoint trustees to administer the proceedings. When bankruptcy is complete, a business's debts are discharged.

Legislative Relief for Small Businesses

Historically, it was difficult and expensive for small business owners to seek bankruptcy protection under Chapter 11. However, the Small Business Reorganization Act (SBRA) of 2019 provides more flexibility to small businesses that file for bankruptcy. The law includes six changes for businesses with no more than $2.75 million (indexed for inflation) in secured and unsecured debts under Subchapter V of Chapter 11.

1. Streamlined reorganizations. The law eliminates certain procedural requirements and lowers costs for small business reorganizations. Significantly, no one except business debtors can propose a reorganization plan. Plus, debtors aren't required to obtain approval or solicit votes for plan confirmation. Absent a court order, there's no unsecured creditor committee. The SBRA also requires courts to hold a status conference within 60 days of a petition filing, giving debtors 90 days to file their plan.
2. New value rule. The SBRA repeals the requirement that equity holders of a small business debtor must provide "new value" to retain their equity interests without fully paying off creditors. Now, the plan must be nondiscriminatory and "fair and equitable." In addition, similar to Chapter 13, the debtor's entire projected disposable income must be applied to payments or the value of the property to be distributed can't be less than the debtor's projected disposable income.
3. Trustee appointments. A standing trustee is appointed to serve as the trustee for the bankruptcy estate. This trustee presides over the reorganization and monitors its progress.
4. Administrative expense claims. Previously, a debtor had to pay any administrative expense claims on the plan's effective date. Under the SBRA, a small business debtor can stretch payment of administrative expense claims over the plan's term, giving this class of debtors a distinct advantage.
5. Residential mortgages. The SBRA eliminates the ban on small business debtors modifying their residential mortgages. Thus, a debtor has more leeway if the underlying loan was used primarily for the debtor's small business. Otherwise, secured lenders continue to have the same protections as in other Chapter 11 cases.
6. Discharges. The SBRA provides that courts must grant debtors a discharge after completing payments within the first three years of a plan (or a longer period of up to five years established by the judge). Discharges relieve debtors of personal liability for all debts under a plan (with certain exceptions).

Important: The debt limit under Subchapter V of Chapter 11 was temporarily raised by other pandemic-era legislation. The inflation-adjusted limit is now $3,024,725 for cases filed after June 20, 2024.

Seeking Outside Expertise

Financial advisors usually play prominent roles in bankruptcies and reorganizations, regardless of the debtor's size. Your SSB CPA can help with the following:

Budget preparation. Companies with inadequate budgets that take on excessive debt may be forced to declare bankruptcy. SSB CPAs can help develop viable reorganization plans. They can even help avert a formal bankruptcy filing with an informal reorganization plan that more effectively allocates working capital, without adversely affecting quality or performance.

Debt management. Financial and legal advisors are instrumental in restructuring debt, including negotiations with creditors. A debtor may be able to lower monthly debt payments to a manageable level through consolidation or elimination of high-interest charges. SSB CPAs may also unearth ways to tap into other resources and avert bankruptcy.

Review of financial condition. Bankruptcy requires a thorough examination of assets and liabilities. Advisors can prepare a statement of financial condition indicating whether any assets are held jointly or in a partnership. The bankruptcy court or IRS may request this statement.

Tax matters. Whether a business is on the verge of bankruptcy or has already filed a bankruptcy petition, SSB can help comply with federal and state tax regulations.

For More Information    

Bankruptcy doesn't necessarily mean the end of your business venture. A reorganization can help distressed businesses recover from a downward spiral. Contact your SSB advisor to discuss your options.

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