(This is part 1 of a 2-part series on small businesses and bankruptcy.)

WHEN THE PRICE of oil nosedived more than 63% to below $10 a barrel in 1986, oil and gas entrepreneur Bill Bartmann lost everything.

Practically overnight, he was forced to lay off all of his 70 employees and shutter the company, which was in the midst of 10 oil exploration projects. His creditors soon came calling, serving involuntary Chapter 7 bankruptcy summonses that sought to liquidate both the company's and Bartmann's personal assets. (Bartmann didn't contest the proceeding against the company, but disputed the filing against his personal holdings and won a dismissal three years later). During the commercial bankruptcy proceeding, Bartmann paid off most of the business's debts. Nevertheless, he wound up $1 million in the hole, his credit was wrecked and he lost two cars to the Internal Revenue Service. “It was totally ugly,” says Bartmann.

As Bartmann can attest, while filing for bankruptcy protection can keep pesky creditors at bay, it also comes at a devastating cost — both financially and personally. Attorney and filing fees for Chapter 11 bankruptcy protection can set the smallest businesses back between $50,000 and $100,000, according to Howard M. Ehrenberg, a business bankruptcy attorney at financial restructuring and litigation firm SulmeyerKupetz in Los Angeles. The cost of filing for Chapter 7, he adds, usually rings in between $5,000 and $10,000. And, here's the real kicker: Sometimes the decision is not even up to the business owner — creditors may do the honors of filing for either Chapter 7 or 11 bankruptcy protection for them.

Roslyn Whitehurst, a spokeswoman for credit reporting company Experian, says a bankruptcy, which is considered a “negative event” on an individual or commercial credit profile, can weigh down a credit report for up to nine years. Such a mar, she says, will likely make getting a loan or even a line of credit incredibly difficult during that time. Even worse, creditors can seize and sell off your personal assets too if you aren't careful, Michelle Dunn, a business debt-collections business owner in Groton, N.H., who has been in the industry for 20 years.

Here are some ways to help limit the potential damage of filing for bankruptcy protection — or possibly avoid it altogether.

Go Corporate

The best way to protect your personal assets from getting seized during a bankruptcy proceeding is to structure the company as either a corporation or a limited liability company, or LLC, suggests Charles J. Schneider, a small-business bankruptcy attorney in Livonia, Mich. Such entities are considered separate under state law, therefore a business owner's personal assets, such as their home and investments, are generally protected from business-related liabilities. (For more information, read our story on corporations and LLCs.)

However, if you're implicated in any sort of business-based wrongdoing such as fraud, negligence or malpractice, operating as a corporation or an LLC won't protect your personal assets from being seized and liquidated by creditors or other damaged parties, says Schneider.

Also, make sure your vendors know your status. Say you initiated a credit relationship with a vendor as a sole proprietor, then transitioned to a single member LLC. If you don't re-sign the contract indicating your new status, that vendor can sue you as an individual since you're still listed as a sole proprietor, says Schneider. "If you want to stay out of trouble, you can't get sloppy."

Sever Personal Ties

Avoid guaranteeing or personally signing for any loans or lines of credit, warns Dunn, the debt-collections expert. If you personally sign or guarantee debt — even if you operate via a limited liability structure — those assets will be fair game should your business file for bankruptcy protection, she says.

Of course, that's a hard thing to do for entrepreneurs who are just starting out. Typically, banks and other lending institutions won't approve any financing, unless an entrepreneur guarantees a loan with personal assets. One way to handle such a situation is to sign personally for difficult-to-come-by loans in the beginning. Then, once the company has built up a positive credit history, refinance the loans or get new ones that don't have to be guaranteed with personal assets, suggests Dunn.

Communicate with Creditors

If your business is teetering on the financial edge, turn to your lenders before turning to the courts, says Dunn. Call creditors and lenders and explain the company's current hardship. Since they'd much rather get paid than fight for payments during bankruptcy proceedings, they'll likely offer improved payment terms such as lower interest rates, reduced settlement amounts or a repayment plan, she says. Then, keep your creditors abreast of the company's financial situation as it changes.

Bartmann says one of the best things he did before heading to bankruptcy court was to speak with his bank. The bank helped Bartmann liquidate his company. But more importantly, he says, that communication paved the way for him to receive more money later when he started his next venture — a debt-collections company.

Other recent Starting Up columns:

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("Starting Up," a weekly column written by Diana Ransom for smSmallBiz.com, follows entrepreneurs through the early stages of launching a business. Write to her at dransom@smartmoney.com.)