Chapter 7 and Chapter 11: The Two Reliefs

There are two kinds of business owners who walk into my office to discuss bankruptcy. The first are alarmed and premature — a bad quarter, a lost contract, a personal-guaranty demand letter, and they arrive convinced the world is ending. The second are calm and late — the crisis was six months ago, the payroll has been made three times on a personal credit card, and they are asking, in a level voice, what remains to be salvaged.

The premature clients I usually send home with a cash-flow plan and a note in the calendar for ninety days out. The late clients I sit down with immediately, because in a bankruptcy, the difference between six months' preparation and no preparation is not incremental — it is the difference between an orderly result and a disorderly one.

This essay is for the Texas business owner considering, or being forced to consider, whether Chapter 7 or Chapter 11 of the Bankruptcy Code is the appropriate relief. It is not legal advice for any specific matter. It is a candid map of the terrain, drawn from nearly 30 years of practicing on both sides of it.

What the two chapters actually do

Chapter 7 and Chapter 11 are both federal bankruptcy proceedings, but they answer different questions:

• ·Chapter 7 — Liquidation. A court-appointed trustee takes possession of the business's non-exempt assets, sells them, and distributes the proceeds to creditors in a statutory priority order. The business ceases operations, typically permanently. For an individual, most remaining unsecured debts are discharged (subject to certain non-dischargeable categories such as most taxes, student loans, alimony, and debts arising from fraud). For a business entity, there is no discharge — the entity itself is wound up and its unpaid creditors' claims against it become uncollectible only because the entity no longer exists.
• ·Chapter 11 — Reorganization. The debtor (typically remaining in possession, as a 'debtor in possession') proposes a plan of reorganization that restructures debts, sometimes reduces principal, extends maturities, and — if confirmed by the requisite creditor votes and the court — permits the business to continue operating. Chapter 11 is complex, expensive, and time-consuming in its traditional form. Since 2020, however, a streamlined variant — Subchapter V — has made reorganization practical for small businesses in a way it had not been for decades.

Subchapter V — the third option most lawyers do not mention

The Small Business Reorganization Act of 2019, effective February 2020, added Subchapter V to Chapter 11. It is not, in the ordinary sense, a separate chapter — it is an election within Chapter 11 available to small business debtors (currently defined by a debt limit adjusted periodically; as of this writing, roughly $3 million of aggregate non-contingent liquidated debts, though this has been temporarily elevated and Congress has been extending the higher threshold in periodic renewals).

For qualifying small businesses, Subchapter V changes the calculus meaningfully:

• ·No unsecured creditors' committee in the ordinary case — a large source of expense and delay in a standard Chapter 11 is eliminated.
• ·A standing Subchapter V trustee is appointed to facilitate a consensual plan — a mediator-like role rather than an adversary.
• ·Only the debtor may propose a plan — the fear of a hostile competing plan from creditors is removed.
• ·Cramdown is easier — a plan can be confirmed over creditor objection if the debtor commits its projected disposable income to plan payments for three to five years and meets the fair-and-equitable standard as modified for Subchapter V.
• ·The equity holder can retain ownership without paying the absolute-priority-rule premium that has historically constrained small-business reorganization.

For the Texas small business with $500,000 to $3 million in unsecured debt and a genuine operating future, Subchapter V is often the right instrument — not because it is easy, but because for the first time in a generation, the tool is proportionate to the problem.

For the late clients, the calm ones, the difference between six months of preparation and no preparation is not incremental — it is the difference between an orderly result and a disorderly one.

How to choose between them

The choice between Chapter 7, Chapter 11, and Subchapter V is not principally a legal question. It is a business question with legal consequences. Ask, in order:

• ·Is there a viable business post-restructure? A genuine operating enterprise — customers, contracts, a competitive position — that could return to profitability if the debt were rightsized. If not, Chapter 7 (or an assignment for the benefit of creditors) is the honest answer. Chapter 11 does not save businesses whose economics have failed; it restructures businesses whose economics still work.
• ·What is the aggregate debt load? Under the Subchapter V threshold, Subchapter V is almost always the right form of Chapter 11. Above it, traditional Chapter 11 is the only option — and its cost structure raises the bar considerably. Traditional Chapter 11 requires, in most cases, at least a million dollars of enterprise value to be worth the professional-fee investment.
• ·What is the personal-guaranty exposure? Most closely held Texas business owners have personally guaranteed some portion of the business's obligations — landlord, working-capital lender, key vendor. A business Chapter 7 does not discharge the personal guaranty. A business reorganization may — through negotiated releases — resolve the personal-guaranty exposure, particularly when the guaranteed creditor's recovery is meaningful only through the reorganized entity's continued operations.
• ·What are the tax consequences? Debt discharge in bankruptcy is not taxable income (Section 108 of the Internal Revenue Code) — this is one of bankruptcy's underappreciated benefits over out-of-court restructuring, where discharged debt can generate ordinary income to the debtor. But there are attribute-reduction rules that apply. A CPA should be at the table from day one.

What personal Chapter 7 accomplishes

For the individual business owner personally overwhelmed by guarantees and business-related debts, Chapter 7 remains the fastest, cleanest form of relief when the eligibility rules permit it. The means test — a formulaic income screen intended to filter high-income individuals into Chapter 13 — is the first hurdle. Business debt over 50% of total debt exempts the individual from the means test entirely, which is why the individual with personal-guaranty exposure often finds Chapter 7 available even at income levels that would otherwise disqualify her.

Texas exemptions are, by comparison to most states, exceptionally generous. A qualifying homestead is protected without acreage cap in a rural setting and up to 10 acres in an urban setting, without dollar limit — meaning a Texas homeowner's home equity survives a Chapter 7 largely intact where a Florida or California homeowner would be forced to elect between homestead and other assets. Retirement accounts, one motor vehicle (per adult household member), tools of the trade, and certain personal property are also protected under the Texas exemptions or the federal alternatives (Texas is one of the states that allows a debtor to elect between the state and federal exemption schedules).

What personal Chapter 11 accomplishes

Personal Chapter 11 — or, more commonly for individuals with significant business ownership, individual Subchapter V — allows an individual to reorganize personal debt (including business-related guarantees) while retaining assets that would be liquidated in a Chapter 7. It is expensive. It is not for the individual whose main problem is $200,000 of credit-card debt. It is for the individual whose problem is $2 million of guaranteed business debt, a valuable personal residence they intend to keep, and a professional practice they intend to continue operating.

Six months before filing

The single most important thing a business owner considering bankruptcy can do is not the filing itself. It is the six months of disciplined pre-filing planning. Concretely:

• ·Get the books current. A bankruptcy schedule cannot be signed under penalty of perjury from books that have not been reconciled since March. Reconstruct the accounting. Pay the accountant now.
• ·Do not prefer insiders. Payments to insiders (owners, family members, affiliated entities) in the year preceding filing can be clawed back as preferences. Ordinary-course payroll and reasonable compensation are permissible; extraordinary transfers are not.
• ·Do not conceal assets. The fastest way to lose the case, and to face criminal exposure, is to move assets 'for safekeeping' in the months before filing. Every transfer will be discovered.
• ·Pay the taxes that are non-dischargeable. Trust-fund taxes — the employee's share of payroll taxes withheld from wages — are not dischargeable and carry personal-liability exposure for responsible officers. Pay these first, before any other creditor, if there is any liquidity at all.
• ·Consult counsel before the last dollar of retained earnings is spent. Bankruptcy requires filing fees, adequate-protection payments, and professional fees. A business that has run itself completely to zero cannot reorganize; it can only liquidate.

What happens on the day of filing

The moment the petition is filed, the automatic stay (Section 362 of the Bankruptcy Code) issues. Every collection action, every lawsuit, every foreclosure, every wage garnishment against the debtor freezes in place. Landlords cannot lock out the business. Lenders cannot repossess collateral without court permission. The IRS cannot levy.

This moment of legal quiet is, for most business owners, the first they have experienced in months. It is not a permanent state; the case unfolds from there. But the pause it provides is real, and it is what allows the calm work of reorganization or orderly liquidation to begin.

A word on the alternative

Bankruptcy is not always the right answer. Sometimes an out-of-court workout with the two or three creditors that meaningfully matter is faster, quieter, and cheaper. Sometimes an assignment for the benefit of creditors — a state-law liquidation procedure — is more efficient than a Chapter 7. Sometimes the correct answer is a controlled sale of the business as a going concern, with the sale proceeds funding creditor payments outside of any court proceeding.

The role of counsel, in the first meeting, is to evaluate all of these before recommending any.

Closing

Bankruptcy carries a moral weight it does not entirely deserve. The Bankruptcy Code is a considered federal statute, refined over more than a century, whose animating purpose is to provide honest debtors a fresh start and to distribute the loss of business failure equitably among the parties who extended credit to it. Using it is not a failure of character. Refusing to consider it, out of pride, is often a much larger failure — one that consumes personal savings, retirement accounts, and family relationships in service of the illusion that the problem can be solved without it.

The clients who come to me late, and calmly, are almost without exception the ones who come to peace with the situation. They arrive not to preserve pride but to preserve what remains — and what remains, in the Texas exemption regime, in a Subchapter V reorganization, or in a well-planned Chapter 7, is very often more than the client believed possible on the drive to the office.

— Darryl V. Pratt is the Managing Partner of Pratt Law Group, PLLC d/b/a Lone Star Counsel, an Attorney and CPA practicing in Frisco, Texas. He has represented debtors, creditors, and trustees in Chapter 7, Chapter 11, and Subchapter V proceedings across Texas for nearly 30 years. This essay is provided for educational purposes and does not constitute legal advice. For counsel on your specific matter, please request a conference.