Here’s One Way to Provide Small Businesses a Fresh Start

The economic relief package will provide loans. But there is more that government can do.

The coronavirus is already causing an economic crisis in the United States. But no business will be hit harder in the coming weeks and months than small businesses, which account for more than 99 percent of all businesses in the United States and close to 50 percent of all employment. Of these, 73 percent are sole proprietorships and 89 percent have fewer than 20 employees. 

As the virus continues to spread across the nation and people practice social distancing by staying away from stores, restaurants, dry cleaners, it is these mom-and-pop shops that are at biggest risk of failing. As of this writing, a $2 trillion economic relief package has passed the Senate and moved on to the House. It includes some measures that will help many small businesses weather this difficult time, notably a $367 billion loan program

But there are other specific and immediate steps the federal government can take—including easing the path to Chapter 7 bankruptcy—to help America’s small-business owners.

Even in normal times, small businesses have a high failure rate. Only about 50 percent of businesses survive the first five years and only 30 percent survive longer than 10 years. America’s bankruptcy system allows these failed entrepreneurs a “fresh start.”

The concept of a fresh start works especially well for owners of small businesses. By wiping out debts and pardoning failure, American bankruptcy law gives the entrepreneur a chance to bounce back. When businesses fail, entrepreneurs can shield some or all of their assets from creditors by filing under Chapter 7 of the federal bankruptcy laws, the usual route for consumer filings. In 2016, more than 60 percent of bankruptcy cases filed were Chapter 7 claims. Most importantly, entrepreneurs can get an exemption for equity in owner-occupied homes through the homestead exemption. They are also released from any future obligation to repay debts. 

However, there is a lack of consistent bankruptcy policy across the states, and that creates an unintended barrier to small business owners who need relief.

Since the Federal Bankruptcy Code of 1978 was enacted, bankruptcy exemption levels are set by the states and vary widely across states and over time. For example, in seven states or regions (and the U.S. territories of the American Samoa and Puerto Rico), the homestead exemptions are unlimited. In New Jersey and Pennsylvania, they are zero. All other states lie somewhere in between. 

There are also personal property exemptions for items like motor vehicles and jewelry. Research, including mine, shows that the lower the exemptions, the smaller the likelihood of business start-ups in that state. Not surprisingly, the threat of losing their home and property at the time of bankruptcy creates a deterrence to individuals starting a business in the state. 

Other bankruptcy routes include Chapter 11 and Chapter 13, which are reorganization procedures. While Chapter 7 is the usual route for consumer filings, Chapter 13 is available to individuals with regular income and sole proprietors, and Chapter 11 is typically available to corporations or partnerships. The amount of debt discharged approaches that under Chapter 7, but both procedures require the debtor to establish a repayment plan paid for with future income. 

In 2005, Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) with the primary intention of making it harder for individuals to file a Chapter 7 bankruptcy. The reform introduced a means test for Chapter 7, which essentially prevented individuals earning above-average income from wiping out their debt through filing under Chapter 7. Instead, such individuals would be able to file under Chapter 13, which allows debt discharge only after the individual has made some repayments. That process can be cumbersome and bogs down entrepreneurs for months or even years as they work to repay their debts. It feels especially unfair to require it of businesses that shuttered through no fault of their own. 

BAPCPA also lowered exemptions for certain assets, and debtors now need to undergo credit counseling before filing—a costly process and, for many business owners, not particularly useful. My research suggests a modest but unarguably negative impact from some of these changes on small-firm entry decisions. Others find a 50 percent reduction in Chapter 7 filings after the act’s passage, and a 25 percent increase in insolvency, leading to worse outcomes for financially distressed borrowers.

While these provisions may work to reduce bankruptcy abuse in normal economic times, these are not normal economic times. It is in the taxpayers’ interest to do everything reasonably possible to protect small businesses—responsible for creating millions of jobs—from going under. The relief package that is expected to pass soon includes measures that will give direct cash to Americans, which will help them pay for expenses as they lose jobs and incomes. There are also expanded unemployment benefits for workers. And finally, there are billions of dollars in loans to small businesses. These are laudable efforts. However, many small businesses will fail in the next few months, despite these efforts.

Allowing small businesses to have an easier path to a Chapter 7 bankruptcy could provide them a fresh start when the crisis is over. By easing the costs associated with a Chapter 7 filing, removing means-tested filing for a temporary period, and allowing more individuals and small businesses to file and claim unlimited homestead and personal property exemptions for a temporary period, we can provide greater protections to assets of small business owners. 

Our entrepreneurial system is dynamic and there is significant churn with businesses dying and re-entering. Perhaps the best solution to the current crisis, when efforts at helping businesses stay afloat don’t work, is easing the path to bankruptcy. This would allow for a fresh start after the tumult has passed.

Aparna Mathur is a Resident Scholar in Economic Policy Studies at the American Enterprise Institute.

Photograph by Angela Weiss/AFP via Getty Images.