Assess Your Personal Liability for Business Debts
Many small business owners see their businesses as an extension of
themselves. It can be tough (not to mention stressful and costly) to start a
business, and the daring entrepreneurs who make a go of it often pour their
energy, time, and money into their ventures. Perhaps you started your business
with your personal savings or money from an inheritance, use your spouse’s
paycheck (or your paycheck from a day job) to fund its operations, use your own
car for deliveries or sales calls, or have pledged your own property and used
your own credit to get the money you need to keep the business running.
Practices like these can make it hard to figure out where your business’s
finances end and yours begin.
Because their business and personal finances are so often intertwined, small
business owners often face collection efforts against their business assets and
their personal property. In looking at your options, one of your first tasks
will be to figure out which business debts you are personally liable for and
which are owed only by your business.
If you are personally liable for some or all of your business’s debts, they
can be wiped out by filing for Chapter 7 personal bankruptcy. On the other hand,
if you are not personally liable for any business debts—for example, because
your business is organized as a corporation or LLC and you have not voluntarily
pledged your personal credit—you won’t need to file a Chapter 7 personal
bankruptcy action for your business debts. Although your business might need to
file its own business bankruptcy, that’s a different process (one that we don’t
cover in detail in this book).
To figure out whether you are personally liable for your business’s debts,
you’ll need to start by looking at how your business is structured (as a sole
proprietorship, partnership, corporation, or LLC). Even if you’ve formed a
separate business structure that offers limited liability, you may still be
responsible for its debts if you’ve personally guaranteed them or taken other
actions that might put you on the hook, such as signing a lease or contract in
your personal name rather than your capacity as a corporate officer, or pledging
personal property as collateral for a business debt.
CAUTION: Whether your business is organized as a corporation, LLC,
partnership, or sole proprietorship, you are legally responsible to pay
taxes your business withheld from employee paychecks. The IRS isn’t interested
in any of the details: If you withheld those taxes, you are personally liable if
you don’t pay that money to the government.
Sole Proprietorships and Partnerships
If you are the sole owner of your business, and you haven’t filed paperwork
with your state to incorporate or form an LLC, you are a sole proprietor. The
same is true for some businesses owned by a husband and a wife: If you live in a
community property state (discussed below), you and your spouse can run the
business and still call it a sole proprietorship.
Legally, a sole proprietorship is inseparable from its owner; the business
isn’t a separate entity that can take on its own debt. You are personally liable
for every penny that your business can’t pay. If your business doesn’t have
enough cash or assets to pay its debts, creditors can, and often will, go after
your personal assets.
If you are a sole proprietor considering bankruptcy to get rid of your
business debts, you need to file a personal bankruptcy, not a business
bankruptcy. A personal bankruptcy will help you wipe out most types of debts,
whether or not they are related to your business.
The same is true of general partnerships. In a general partnership, each
partner is personally liable for 100% of the partnership’s debts. If there
aren’t enough business assets to pay those debts, and your partners are broke,
creditors can take your personal assets to pay all of the business’s
debts, not just your pro rata share. But fortunately, filing a personal
bankruptcy will get rid of all of your liability for the partnership’s debts, as
well as any money you owe to your partners.
Corporation or LLC
If your business is organized as a corporation or LLC, you and your business
are separate legal entities. You have limited liability for the business’s
debts. In theory at least, this means you aren’t personally liable for the debts
of your business, so creditors can’t take your house or other personal assets to
pay business debts, even if your business can’t pay them.
Example: Cook’s Nook, Inc., orders kitchen supplies
from 20 wholesalers before the business tanks. Unable to pay its expenses, the
corporation closes its doors. Talia, the corporation’s sole owner, auctions off
the store’s inventory and uses the proceeds to pay Cook’s Nook’s creditors, who
receive a few cents on the dollar. She then dissolves the corporation by filing
dissolution papers with the state. Because the business is a corporation, Talia
is not personally responsible for paying any of Cook’s Nook Inc.’s remaining
debt. Its creditors are simply out of luck.
Unfortunately for small business owners, legal theory is not necessarily
legal reality. There are many ways corporate shareholders or LLC members can
make themselves personally liable for business debts. In fact, most owners of
small corporations and LLCs voluntarily take on personal liability for at least
some business debts.
Below are some common ways an owner of a corporation or an LLC might become
personally liable for the business’s debts. If you are personally liable for
some or all of your business debts, you will have to file a personal bankruptcy,
rather than a business bankruptcy, to rid yourself of these debts.
Signing a Personal Guarantee
Because most suppliers, banks, and landlords know that corporate shareholders
and LLC members aren’t personally liable for business debts, they often won’t
extend credit or lend money to a small corporation or LLC without an owner’s
personal guarantee: a legally binding agreement that the owner will repay the
debt if the business can’t. And many small business owners are willing to sign a
personal guarantee, even though they incorporated or formed an LLC precisely to
limit their liability for obligations relating to the business, because they
can’t get the money otherwise.
Check to see whether you signed a personal guarantee on any of your business
contracts, such as a loan for a business vehicle or business equipment, trade
terms with a supplier, a bank line of credit, or a commercial lease. If so, the
creditor can go after your personal assets for repayment.
Offering Your Property as Collateral
Banks often require the owners of small corporations or LLCs to put up their
home or other real estate as security for a loan. If you secured a business loan
or debt by pledging personal property, such as your house, boat, or car, you are
personally liable for the debt. If your business defaults on the loan, the
lender or creditor can sue you to foreclose on the property (collateral) and use
the proceeds to repay the debt. Filing for Chapter 7 personal bankruptcy will
wipe out your personal liability for this type of loan, but the lender’s lien on
the collateral will survive. This means you’ll eventually have to pay off the
debt if you sell the property; what happens to liens in bankruptcy is covered in
Ch. 8.
Signing a Contract in Your Own Name
You may also have given up your limited liability if you were careless about
signing purchase agreements and service contracts for your business. Sometimes
these agreements display the personal name of the business owner without the
name of the corporation or LLC. If you signed an agreement in your personal name
and not on behalf of the corporation or LLC, you’re personally liable for the
underlying debt, even if it was a simple mistake. If you’re not sure whether you
signed an agreement or loan personally, check the language of the agreement and
the signature block to see whether you signed it in your name or in your
capacity as an owner or officer.
Example: Talia signs a loan contract as Talia
Smith, CEO of Cook’s Nook, Inc., which means only her incorporated business is
liable to repay the loan. But Talia then signs her commercial lease as just
Talia Smith (without any mention of Cook’s Nook, Inc.). Talia will be personally
liable to the landlord if her business can’t pay the rent.
Using Credit Cards or Personal Loans to Fund the Business
If you used credit cards or home equity loans to obtain funds for your
business, you are personally liable for those debts. (Under the terms of most
credit card applications, even those used in the name of a corporation or LLC,
you agree to be personally liable for making all payments.)
Example: Amy and Adam open a coffee roastery and café
offering weekly poetry readings. To get their business started, they file LLC
formation papers with the state and spend $35,000 on a brand new roaster that
can crank out a thousand pounds of coffee per day. Unable to get a small
business loan, they charge the coffee roaster on their personal credit cards,
figuring they will pay it off quickly with income from the business. They also
sign a two-year lease on a corner building in an artsy neighborhood, for which
the landlord requires their personal signatures. They arrange for weekly
deliveries of beans from a nearby wholesaler, with invoices in the name of Cozy
Roast LLC.
Unfortunately, when they open their doors, crowds fail to appear, and Amy and
Adam realize that their original sales forecast was too optimistic by half. Five
months later, still operating in the red, they decide to close down. They are
personally liable for their $35,000 credit card debt for the coffee roaster as
well as the remaining months on their two-year lease (unless the landlord can
find a replacement tenant). Because Amy and Adam didn’t personally sign or
guarantee a contract for the coffee bean deliveries, only the business is liable
to pay the bean invoices (assuming Amy and Adam have properly followed LLC
formalities). Amy and Adam consider filing for Chapter 7 personal bankruptcy to
get rid of their credit card debt and obligation to the landlord.
Tortious Conduct
Generally, owners of corporations and LLCs are not personally liable for
mistakes in management, but they can be held personally liable for injuring
others. An owner who commits a tort (the legal term for an act that harms
another person and causes monetary loss) can be held personally liable.
Example: Brian, the owner of an LLC, speeds through
a residential neighborhood and runs a red light, causing an accident. Damages to
the other vehicles, which were totaled, exceed his $50,000 liability insurance
policy by $40,000 (he hit a Lexus and a Mercedes). Even though Brian was driving
on work-related business, the LLC’s limited liability does not protect Brian
from being sued personally for the automobile damages.
Fraud, Misrepresentation, or Sloppy Record Keeping
If you misrepresented or lied about any facts when you applied for a loan or
credit on behalf of your corporation or LLC, you could be held personally liable
for the debt. Likewise, if you failed to maintain a formal legal separation
between your business and your personal financial affairs, creditors could try
to hold you personally responsible for the business’s debts under a theory known
as “piercing the corporate veil.” This happens when a court finds that your
corporation or LLC is really just a sham and you are personally operating the
business as if the corporation or LLC didn’t exist. In this situation, a court
may decide that you aren’t entitled to the limited liability that your business
structure would ordinarily provide.
One way creditors try to pierce the corporate veil is by showing that you
didn’t observe the legal formalities imposed on corporations and LLCs. For
instance, you may have made important corporate or LLC decisions without
recording them in minutes of a meeting. Or, you may have paid business bills
from a personal checking or credit card account or paid personal bills from your
business bank account. Even corporations or LLCs owned by a single individual or
a married couple have to obey the rules and formalities imposed on these
business structures; otherwise, they risk losing their limited liability
protection.
TIP: List
all business debts in your personal bankruptcy filing, just in case your “veil”
is pieced. Even if you don’t think you are personally liable for a
corporate or LLC debt, you should list all business debts when you file
for Chapter 7 personal bankruptcy. Business creditors might try to pierce your
corporate veil and sue you personally for those debts. But if you list your
business creditors in your personal Chapter 7 paperwork, any potential personal
liability for the business debt will be extinguished in the Chapter 7 personal
bankruptcy—even though the business debt will remain on the corporation or LLC’s
books. If you’re concerned about personal liability for your corporation’s or
LLC’s debts, you should also talk to a lawyer to make sure you’re doing all you
can to protect yourself. At a minimum, when you list these business debts in
your bankruptcy forms, check the “disputed” column (see Ch. 9), so you won’t be
admitting liability down the road if any of these debts survive your
bankruptcy.
Contact your Montgomery County Bankruptcy Attorney or
Baltimore Bankruptcy Attorney to discuss your options if you own a business and are facing overwhelming debt.
Reprinted with permission, Nolo.com