Can You Discharge an SBA Business Loan in Bankruptcy? (2024)

Many people take out Small Business Administration (SBA) loans to start or expand their businesses. However, if the company fails, borrowers find themselves on the hook for the SBA loan. Luckily, you can "discharge" or eliminate your obligation to pay back an SBA loan by filing for bankruptcy.

But remember that if you pledged assets as collateral, you will lose them if you don't pay as agreed. Bankruptcy won't erase the type of lien you would have given on the property. Read on to learn more about how to discharge your SBA loan, along with other qualifying debts in bankruptcy.

What Is an SBA Loan?

The United States Small Business Administration is a federal agency that supports individuals who wish to start a small business. One function of the SBA is to provide loan assistance to small business owners. The SBA works by matching borrowers and SBA lenders and guaranteeing a portion of the loan, making obtaining the financing you need easier.

Bankruptcy Eliminates SBA Loan Payments

Because the SBA is a federal agency, many people mistakenly believe that SBA loans are not dischargeable in bankruptcy. But that's not the case. If you can't afford to repay your SBA loan, you can eliminate your liability by filing for bankruptcy relief.

Bankruptcy works by automatically breaking the contract that requires you to repay a creditor for a debt you can erase in bankruptcy. For instance, bankruptcy will eliminate a filer's responsibility to pay credit card balances, mortgages, car loans, utility bills, and other qualifying debts, but not student loans (without filing a separate lawsuit), support arrears, recently incurred tax debt, and other debts that survive bankruptcy.

What Is a Property Lien?

A lien is a security interest on a debtor's property that remains until the debtor repays a loan or another obligation. A lien creates a "secured" debt because the property helps ensure the borrower repays the debt.

If the borrower doesn't pay, the lender can foreclose or repossess the property, sell it, and use the proceeds to reduce the balance owed. The lender can also wait until the borrower sells the property to receive payment from the proceeds. The lien must be paid before the new owner can obtain a clear title.

These rules apply to all loans in which the borrower voluntarily agrees to give the lender collateral to guarantee a debt. For instance, you must continue paying your mortgage to protect your home in bankruptcy. The same rules apply to keep a car in bankruptcy.

Bankruptcy Doesn't Erase Most SBA Loan Liens

The reason people sometimes believe they can't discharge an SBA loan isn't because of the loan itself. The confusion arises because bankruptcy rarely removes liens, and it's common for an SBA lender to have one of several lien types.

After bankruptcy, the lender can't force you to pay the discharged debt using collection tactics like garnishing your wages or withdrawing funds from a bank account. However, when the lien remains, the lender can still recover the property through foreclosure or repossession or wait to get paid once the property is sold.

Does My SBA Lender Have a Lien?

It's possible. However, an answer that can be applied in every case doesn't exist. Many SBA lenders require collateral as reassurance that you'll pay the debt, which is typical when borrowing significant amounts of money. But SBA loans aren't all the same.

An SBA lender's lien rights will depend on the original loan transaction and the lender's steps after funding and before the bankruptcy filing.

Pledging Property as Collateral for a Debt

When you pledge collateral to guarantee payment of an SBA loan, such as a home or car, you create a secured debt by giving the lender a "voluntary lien" on the property. A lender with a voluntary lien isn't required to sue to acquire lien rights because you agree to the lien as a condition of receiving the loan.

Pledging Personal Responsibility to Pay a Business Debt

When a new or struggling business requires credit, the lender often requires an individual stakeholder to sign some form of a personal guarantee. The personal guarantee makes the individual personally liable for company debt, which, in this case, would be the SBA loan.

A personal guarantee alone is an "unsecured" obligation because it doesn't give the lender a lien on property. If the borrower "defaults" by not paying as agreed, a lender with an unsecured debt can ask for payment but can't recover property or use more aggressive collection techniques.

Converting an Unsecured Debt Into a Secured Debt

A lender with an unsecured loan can increase the lender's collection abilities by suing the borrower in court. If the creditor wins, the court will issue a money judgment that allows the lender to garnish wages, withdraw funds from bank accounts, seize assets, and place "judgment liens" against the judgment debtor's property. In some states, a money judgment automatically places a judgment lien on the debtor's property.

For bankruptcy purposes, the important factor is that winning a collection lawsuit gives the creditor the right to place an involuntary judgment lien against property, which turns an unsecured debt into a secured debt guaranteed by the lien property.

SBA Liens in Bankruptcy Chapters 7 and 13

You'll be in a good bankruptcy position if the lender doesn't have a lien because you'll be able to discharge the debt in Chapters 7 and 13 without worrying about losing property. If the lender has a lien, the outcome will depend on the lien type, the property, and whether you file for Chapter 7 or 13.

Voluntary liens don't go away in bankruptcy. If you agreed to a lien when you took out a loan, you'll be stuck with it. You will lose the collateral unless you can repay the debt and protect the property equity with a "bankruptcy exemption" (or pay for any nonexempt equity). Bankruptcy exemptions are the laws that allow people to keep specific property in a bankruptcy case.

Unlike voluntary liens, you can remove a judgment lien if it impairs your ability to retain personal property protected by a bankruptcy exemption. However, if the lien amount exceeds the bankruptcy exemption, the portion of the lien that doesn't impair your exemption rights will remain in place.

Removing all or part of a judgment lien in bankruptcy isn't automatic. It requires filing a motion with the bankruptcy court.

Voluntary Liens in Chapter 7 Bankruptcy

If you file for Chapter 7 bankruptcy and are behind on the SBA payment, a lender with a voluntary lien has two options. The lender can ask the court to lift the automatic stay—the order that prevents creditors from collecting during bankruptcy—to allow the lender to recover the property. The lender's other option is to wait until after the bankruptcy ends.

To keep the property and keep the lender at bay, you must pay what you owe. You'll also need to be able to protect the property equity with bankruptcy exemptions to keep the Chapter 7 trustee from selling the property for the benefit of creditors.

Example. John voluntarily guaranteed his $100,000 SBA loan by giving the lender a lien on his car worth $10,000. John still owed $75,000 on the SBA loan when he filed for Chapter 7 and discharged the entire amount. After the case ended, the lender used its lien rights to repossess the vehicle.

Judgment Liens in Chapter 7 Bankruptcy

The same rules apply if the lender has a judgment lien. However, the bankruptcy court will remove a judgment lien if it impairs a bankruptcy exemption on personal property. So, if a bankruptcy exemption allows you to protect equity in property with a judgment lien on it, the bankruptcy court will remove the lien up to the exemption amount.

Example. Paula filed for Chapter 7 after her SBA lender obtained a judgment lien against her car for $10,000. Paula's state allowed her to exempt $15,000 in vehicle equity. Because honoring the $10,000 judgment lien would impair Paula's ability to protect her car's equity with the bankruptcy exemption, the judge granted her motion to remove the judgment lien.

SBA Liens in Chapter 13 Bankruptcy

In Chapter 13, the Chapter 13 trustee doesn't sell property. Instead, the debtor must pay the lender the amount owed through the Chapter 13 plan to keep the property, plus pay for any nonexempt equity not covered by a bankruptcy exemption. If the lender has a judgment lien against personal property, the debtor can reduce the lien by the exemption amount.

Example. Christine owed $5,000 on an SBA loan she secured with her car. Because Christine had fallen behind on the SBA payment and didn't want to lose the car, she filed for Chapter 13 and paid off the remaining $5,000 through her five-year Chapter 13 plan.

Consult a Bankruptcy Lawyer

Addressing liens is one of the more complicated areas of bankruptcy law, and each filer's case is unique. Consider meeting with a bankruptcy attorney familiar with small business issues to ensure you appropriately protect your assets.