Bankruptcy for Self-Employed Individuals

The path of self-employment is often fueled by vision, autonomy, and considerable effort. Yet, this independence can come with distinct financial exposures. Unpredictable income, abrupt economic changes, or the weight of business obligations can create significant financial strain for freelancers, independent contractors, and sole proprietors. If this describes your current situation, be assured that effective legal avenues are available to help you restore financial stability and achieve a new beginning. Bankruptcy, a process established under federal law, offers potent relief tailored for these intricate circumstances.

Your Bankruptcy Options as a Self-Employed Individual

Selecting the appropriate bankruptcy chapter is a critical step. Below, we describe the main options available to self-employed individuals.

Chapter 7 Bankruptcy (Liquidation)

Chapter 7 bankruptcy offers a route to a “fresh start” by eliminating many kinds of unsecured debt. The procedure involves a court-appointed trustee who may sell your assets that are not protected by law (“non-exempt” assets), with the funds distributed to your creditors.

For a self-employed individual, this requires a comprehensive review of both personal and business assets. Assets classified as “exempt” under applicable bankruptcy laws (which can include a certain amount of equity in a home, personal items, and often, tools of the trade up to a specified value) are shielded from liquidation. However, if your business depends on significant non-exempt assets (such as valuable equipment or inventory exceeding exemption allowances), Chapter 7 could result in the sale of these items and, possibly, the closure of your business if those assets are indispensable.

A key element for many individuals contemplating Chapter 7 is the “means test.” This test assesses your income against the applicable median income for a household of your size to see if you have enough disposable income to repay some of your debts. A notable benefit for many self-employed individuals is that if the bulk of your debts are business-related (“non-consumer” debts) rather than personal or household debts, you might be excused from the income limitations of the means test. This can make Chapter 7 a more attainable option even if your income might otherwise seem too high.

Upon the successful conclusion of a Chapter 7 case, you obtain a discharge, which legally absolves you from the duty to pay many common debts, like credit card balances, medical bills, and personal loans. Some debts, however, are typically non-dischargeable, including recent tax liabilities, child support, alimony, and most student loans. It is also pertinent that while an individual owner of an LLC or corporation can secure a personal discharge in Chapter 7, the business entity itself does not obtain such a discharge.

Chapter 13 Bankruptcy (Reorganization)

Chapter 13 bankruptcy presents a different strategy, enabling self-employed individuals to reorganize their finances and repay debts over a three to five-year timeframe while generally retaining their assets, including their business. This chapter is often chosen by those who intend to continue their business operations and possess a regular source of income to support a repayment plan.

Eligibility for Chapter 13 necessitates that your secured and unsecured debts are below certain statutory thresholds (these thresholds are adjusted periodically). You must also show that you have “regular income” adequate to make plan payments. For the self-employed, “regular income” does not strictly mean a fixed salary; income from your business activities, even if it varies, can qualify, but it will demand meticulous documentation and projection.

The foundation of a Chapter 13 case is the repayment plan. This plan, created with your lawyer, details how you will compensate your creditors over the plan’s duration. It usually gives precedence to certain debts, such as secured debts (like a mortgage or vehicle loan you wish to keep current) and priority debts (like specific taxes or domestic support payments).

The sum paid to unsecured creditors is influenced by factors like your disposable income and the value of your non-exempt assets (as you must pay them at least what they would have obtained in a Chapter 7 liquidation). A bankruptcy trustee is designated to assess your proposed plan, receive your monthly payments, and allocate the funds to your creditors. The trustee might also oversee your business’s financial activity during the plan.

Upon successfully making all payments under the confirmed Chapter 13 plan, you receive a discharge of any remaining eligible debts. This can encompass a wider array of debts than in Chapter 7 for some filers.

Chapter 11 Bankruptcy (Reorganization)

Chapter 11 bankruptcy is another form of reorganization, historically utilized by larger companies, but it is also accessible to individuals, including self-employed business owners. This chapter is generally more intricate and can be costlier than Chapter 7 or Chapter 13. It becomes a relevant consideration for self-employed individuals whose debts surpass the limits for Chapter 13 or whose business affairs are especially complex and necessitate a more adaptable restructuring model.

A newer provision, Subchapter V of Chapter 11, is specifically structured to make the reorganization process more efficient and less expensive for small businesses, which can include sole proprietors, freelancers, and independent contractors. This can be an excellent choice if Chapter 13 is not suitable due to debt amounts, but a full Chapter 11 seems too unwieldy. Subchapter V provides tools for owner-operated businesses to restructure debts, maintain ownership, and sustain operations.

Key Considerations for the Self-Employed

Filing for bankruptcy when you are self-employed involves several distinct points that differ from those encountered by traditional employees.

1. Defining Income: For bankruptcy calculations, your income is not merely your personal draw from the business; it is typically based on the business’s net profit. You will need to furnish extensive documentation, including profit and loss statements, bank statements (both business and personal), filed tax returns (such as Schedule C for sole proprietors or appropriate forms for partnerships/S-corps), and potentially invoices or 1099 forms. Accurately computing your current monthly income is vital for the means test in Chapter 7 and for establishing your disposable income for a Chapter 13 repayment plan.

2. Business Assets: The handling of business assets (like equipment, tools, inventory, vehicles, accounts receivable, and intellectual property) differs between chapters.

• In Chapter 7, non-exempt business assets might be liquidated by the trustee. Exemption laws permit you to protect certain kinds and amounts of property, including “tools of the trade” up to a certain value. 
• In Chapter 13, you generally retain your assets, but the value of your non-exempt business assets will affect how much you must repay unsecured creditors through your plan. 

3. Business Debts and Personal Guarantees: As a sole proprietor, there is no legal separation between your personal debts and your business debts; you are responsible for all of them. If your business is structured as an LLC or corporation, the entity is legally distinct. However, lenders frequently require small business owners to issue personal guarantees for business loans or leases. If you have personally guaranteed a business debt, you remain personally liable even if the business ceases operations. Personal bankruptcy (Chapter 7 or 13) can address these personally guaranteed liabilities. Chapter 13 may provide mechanisms to manage and potentially discharge liability from such guarantees over the plan’s term.

4. Tax Obligations: Tax matters can be quite involved in bankruptcy. You must have filed all requisite tax returns for recent years to be eligible for certain bankruptcy protections. Some older income tax debts may be dischargeable in bankruptcy if they meet specific conditions (e.g., the tax return was due at least three years ago, filed at least two years ago, and the tax was assessed at least 240 days ago, among other stipulations). However, “trust fund” taxes, such as payroll taxes withheld from employees or certain sales taxes collected, are generally not dischargeable.

5. Importance of Accurate Financial Records: Well-maintained and precise financial records are indispensable for a trouble-free bankruptcy process when you are self-employed. They are required for completing your bankruptcy petition and schedules correctly, substantiating your income and expenses for the means test or Chapter 13 plan, and offering transparency to the bankruptcy trustee. Disarrayed or deficient records can cause delays, complications, or even endanger your case.

6. Continuing Business Operations: Many self-employed individuals aspire to continue their business.

• Chapter 13 is specifically structured to permit this, assuming your plan is viable and you can sustain payments. You will typically need to submit regular operating reports to the trustee.
• Chapter 11 (especially Subchapter V) also supports ongoing business activities during reorganization.
• In Chapter 7, continuing operations hinge on whether essential business assets are exempt. If your business is primarily service-based with minimal assets, or if all essential assets are shielded by exemptions, you may be able to persist.

7. Credit After Bankruptcy: Filing for bankruptcy will affect your credit score. However, it also furnishes a potent means for resolving overwhelming debt, which itself can be a significant impediment to good credit. Many self-employed individuals discover that after obtaining a bankruptcy discharge, they are in an improved position to begin rebuilding their credit prudently over time. It represents an opportunity for a genuine financial fresh start.

Preparing for Bankruptcy as a Self-Employed Individual

Comprehensive preparation is fundamental to a successful bankruptcy filing, especially for those who are self-employed.

1. Gathering Financial Documents: You will need to assemble an extensive collection of financial documents. Absent or incomplete paperwork can lead to substantial delays. Key documents generally include:

• Federal and any applicable state tax returns for the last two to four years, with all schedules and attachments (e.g., Schedule C, K-1s).
• Business bank account statements for at least the preceding six to twelve months.
• Personal bank account statements for the identical period.
• Current year-to-date profit and loss statements and for the previous one to two complete years.
• A detailed inventory of all business and personal debts, including creditor names, current balances, account numbers, and addresses.
• A thorough list of all business and personal assets, with their estimated current fair market values (e.g., real estate, vehicles, equipment, inventory, bank balances, investments, accounts receivable).
• Copies of significant business contracts, commercial leases, equipment leases, and loan agreements.
• Identification (driver’s license, Social Security card).

2. The Means Test (for Chapter 7): If a considerable portion of your debt is consumer debt (rather than business debt), you will need to undergo the means test to ascertain your eligibility for Chapter 7. This test examines your average income for the six months before filing and compares it to allowable expenses. A proficient bankruptcy attorney can help you accurately calculate your income and expenses and determine if the means test is relevant to your circumstances.

3. Credit Counseling: Before you can initiate any chapter of bankruptcy, you are mandated to complete a credit counseling course from an agency sanctioned by the U.S. Trustee’s office. This course, typically available online or by phone, furnishes an overview of your financial state and alternatives to bankruptcy.

4. Statement of Financial Affairs and Schedules: These are the primary documents submitted to the bankruptcy court. They offer a complete depiction of your financial condition, encompassing all your assets, debts, income, expenses, and recent financial dealings (like payments to creditors, asset sales, or transfers). Utmost accuracy and full disclosure are essential.

The Bankruptcy Process: A General Overview

While the particulars differ between chapters, the general bankruptcy procedure for a self-employed individual typically follows these main phases:

1. Filing the Petition: The process formally commences when you (or your lawyer) file a bankruptcy petition and other requisite forms with the United States Bankruptcy Court where you reside or have your principal place of business. Upon filing, an “automatic stay” takes immediate effect. This potent court directive halts most collection activities by creditors, including lawsuits, wage garnishments, foreclosures, and persistent phone calls.

2. Meeting of Creditors (341 Meeting): Roughly 20 to 40 days after filing, you are required to attend a meeting of creditors, often termed a “341 meeting” after the pertinent section of the Bankruptcy Code. Despite its designation, creditors seldom attend to individual cases. The meeting is overseen by the bankruptcy trustee assigned to your case. You will be placed under oath and questioned about your bankruptcy petition, schedules, financial dealings, assets, and debts. Your attorney will accompany you.

3. Trustee Involvement: The bankruptcy trustee assumes a central role.

• In Chapter 7, the trustee reviews your documentation, inspects your assets to identify any non-exempt property that can be sold for the benefit of creditors, and may probe your financial history.
• In Chapter 13 (and Chapter 11), the trustee assesses your proposed repayment plan for feasibility and adherence to bankruptcy law, collects your plan payments, and distributes those payments to your creditors as per the confirmed plan. They may also necessitate your submission of periodic reports on your business’s income and expenditures.

4. Developing a Repayment Plan (Chapter 13/11): If you file under Chapter 13 or Chapter 11, you (with your attorney’s assistance) will put forward a repayment plan. This plan specifies how you aim to repay your creditors over time. Creditors and the trustee have an opportunity to raise objections to the plan. The bankruptcy court must ultimately confirm (approve) the plan for it to be binding.

5. Discharge: The concluding step in a successful bankruptcy case is the receipt of a discharge order from the court. This order legally frees you from personal liability for the debts covered by the discharge. It effectively renders those debts uncollectible. The timing and extent of the discharge depend on whether you filed Chapter 7, 13, or 11.

Navigating Self-Employed Bankruptcy in Alabama? Contact Padgett & Robertson for Skilled Legal Guidance

The bankruptcy process, especially for self-employed individuals, is complex and regulated by intricate federal and local laws. Attempting to manage it independently can result in expensive errors, loss of assets that might otherwise have been protected, or even dismissal of your case.

At Padgett & Robertson, we acknowledge the immense effort you have dedicated to your business. Our method involves providing individualized, empathetic, and strategic legal counsel. We dedicate the time to meticulously analyze your unique position as a self-employed individual, explain your options in straightforward terms, and devise a tailored legal approach designed to secure the best possible result for you and your enterprise.

We are focused on helping you progress towards a more secure financial future.