While often used interchangeably, bankruptcy and insolvency are distinct concepts. Insolvency is a financial state in which a business is unable to pay its debts because its assets are insufficient to meet its liabilities. On the other hand, bankruptcy is the legal procedure that is initiated when an insolvent party is unable to settle their debts through other means.

One key difference between the two is that insolvency can sometimes be resolved without the need to go to court. According to Lexington Law, there are five steps an individual or business can take when they become insolvent:

Step 1: Debt management

A debt counselor or debt management company can help you find options for dealing with your insolvency. You may even be able to find nonprofit help in your area. They can assist you with a plan of action to pay or settle your debts, which often includes either debt restructuring or debt consolidation.

Debt restructuring involves renegotiating the terms of an existing debt to make payments more manageable. With debt consolidation, borrowers can pay off multiple debts by taking out a new loan, often at a lower interest rate.

Step 2: Try to negotiate a settlement for your debts

Negotiating your debts can be done with or without outside help. Assuming your creditors are willing, you can also contact your creditors directly to settle the debt at a lower price. If you are dealing with collection agencies, it can also be helpful to know debt collection laws.

Step 3: Find out if you owe taxes

If you’re able to settle your debts, you may be liable for taxes. This can happen if the creditor writes off your debt in a settlement. To find out if you owe any taxes, it’s helpful to contact a tax professional or credit counseling agency.

Step 4: Check if you are eligible for an insolvency order

An insolvency order happens through the courts and protects you from filing for bankruptcy. If approved, the insolvency order may also prevent debt collection efforts temporarily.

Step 5: Seek legal counsel

Finally, it may be beneficial to contact legal counsel. You may be dealing with illegal debt collection practices that you’re unaware of. By working with a lawyer, you’ll receive professional advice to ensure you handle your insolvency properly.

If these steps don’t right the ship, bankruptcy offers individuals and businesses a financial fresh start. This process involves forgiving specific debts, restructuring payment plans, or liquidating assets to satisfy creditors. Bankruptcy is generally a last resort when other debt management options have failed. There are different types of bankruptcies, which are usually referred to by their chapter in the U.S. Bankruptcy Code.

Types of Bankruptcy (as defined by UScourts.gov)

Chapter 7 – The chapter of the Bankruptcy Code providing for “liquidation,”(i.e., the sale of a debtor’s property and the distribution of the proceeds to creditors). Typically, businesses with little chance of recovery opt for Chapter 7 bankruptcy. 

Chapter 11 – The chapter of the Bankruptcy Code provides (generally) for reorganization, usually involving a corporation or partnership. A chapter 11 debtor usually proposes a plan of reorganization to keep its business alive and pay creditors over time. People in business or individuals can also seek relief in chapter 11.

Chapter 13 – The chapter of the Bankruptcy Code providing for adjustment of debts of an individual with regular income. (Chapter 13 allows a debtor to keep property and pay debts over time, usually three to five years).

Chapter 15 – The chapter of the Bankruptcy Code dealing with cases of cross-border insolvency.

Insolvency can arise from various factors including poor cash flow management, economic downturns, customer loss, legal disputes, or unexpected expenses. While these challenges can be daunting, many businesses can recover their financial footing through strategic solutions. However, if these efforts prove unsuccessful, bankruptcy may become a necessary step.