The U.S. personal bankruptcy system functions as a bankruptcy system for small businesses as well as for consumers. When firms are non-corporate, debts of the firm are personal liabilities of the entrepreneur/owner. If the firm fails, the entrepreneur has an incentive to file for bankruptcy under Chapter 7, since both business debts and the entrepreneur's personal debts will be discharged. The entrepreneur must give up assets above a fixed bankruptcy exemption level for repayment to creditors, but future earnings are entirely exempt. Exemption levels are set by the states and they vary widely.
We show that higher bankruptcy exemption levels benefit potential entrepreneurs by providing partial wealth insurance. The predicted relationship between the probability of owning a business and the exemption level is positive at low exemption levels, but may be either positive or negative at high exemption levels, depending on whether higher bankruptcy costs outweigh the gain from additional insurance. We test this prediction and find that the probability of families who are homeowners being self-employed is 35% higher if families live in states with unlimited exemptions rather than low exemptions. We also find evidence that families who are homeowners are more likely to start businesses and to organize their businesses as non-corporate rather than corporate if they live in states with high or unlimited, rather than low, bankruptcy exemptions.
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