How does the U.S. personal bankruptcy procedure affect small businesses? Because most small businesses are unincorporated, debts are personal liabilities of the business owner. Lending to those small businesses is legally equivalent to lending to their owners. If the business fails, the owner is likely to have large business debts that legally are personal debts. The Chapter 7 procedure of current U.S. bankruptcy law provides two important protections for small business owners who are faced with business debt:
Future earnings First, owners of failed businesses can file for personal bankruptcy, in which their unsecured personal and business debts are discharged. Their future earnings are exempt from the obligation to repay debt, so they can start new businesses or take jobs working for others without having their future earnings taxed to repay their pre-bankruptcy debt. The future earnings provision -- referred to as the "fresh start" -- applies uniformly throughout the United States.
Current assets Second, business owners (like other bankrupt debtors) must surrender current assets that are above an exemption level set by the state in which they live. The non-exempt assets, in turn, are used to repay debt. Because the exemptions vary by state, states with higher bankruptcy exemptions are more attractive to entrepreneurs. Most states have several bankruptcy exemptions for different types of assets, but the most important is the exemption for equity in an owner-occupied home (the "homestead" exemption). Seven states have unlimited homestead exemptions: Arkansas, Florida, Iowa, Kansas, Minnesota, Oklahoma, and Texas. Unlimited exemptions allow individuals or couples who file for bankruptcy to shelter millions of dollars of assets from creditors, as long as the assets are converted into equity in an owner-occupied home before the bankruptcy filing occurs. Several other states have homestead exemptions of $100,000 or more. At the other end of the spectrum, Maryland and Delaware have no homestead exemption at all and seven other states have homestead exemptions of $5,000 or less. Besides the homestead exemption, most states also exempt clothing, furniture, and cooking utensils, and have small exemptions for other types of personal property and some retirement accounts. In states with the highest exemptions, owners of failed businesses can shelter assets worth millions of dollars. That encourages even risk-averse individuals to go into business. In states with low exemptions, owners of failed busi nesses can shelter their clothes, furniture and cooking utensils, but little else. That discourages risk-averse individuals from going into business.
How does the variation in bankruptcy exemption levels affect small business? We can hypothesize that, in states with high exemption levels, individuals would be more likely to own businesses because the more generous exemptions cushion entrepreneurs against the consequences of business failure. We can also hypothesize that lenders would be more likely to deny applications for credit from small businesses in high exemption states because entrepreneurs in those states would be more likely to file for bankruptcy and would repay less when they file. To test the hypotheses, two fellow researchers and I examined the entrepreneurship and lending patterns in states with different exemption levels. Specifically, we used the homestead exemption as the basis for comparison because it is the largest exemption in nearly all states and it is also the most variable. As we made the comparisons between states, we kept in mind that renters cannot make use of homestead exemptions and, therefore, they cannot shelter as many assets when they file for bankruptcy. Bankruptcy therefore provides a much more generous "insurance policy" for homeowners who go into business than for renters.
