If your business is in distress — you owe a lot of money but you can’t pay, your creditors will probably threaten legal action against your business and very likely, you personally as well. How much they can collect, and how they can go about collecting it, will depend on how your business is organized, and whether you personally guaranteed repayment of the obligation.
To what extent you are personally liable depends on several factors, the most important being, how your business is structured and whether you personally guaranteed or secured the debt.
Sole Proprietors and Partnerships
If you are a sole proprietor, you and your business are one and the same in the eyes of the law, which means you are personally responsible for all of the business’s debts. If there isn’t enough money in the business to pay these debts, creditors can take your personal assets to pay them.
Partners in a general partnership have similar personal liability for business debts: Each partner is personally liable for the entirety of the business’s debts (and any partner can usually bind the entire partnership to a business deal — a scary combination). This means that if there isn’t enough money in the business to pay the debts, and your partners are broke, creditors can take your personal assets to pay all of the business’s debts, not just your share.
Corporations and Limited Liability Companies
If your business is organized as a corporation or a limited liability company (LLC), your personal assets are usually protected from business creditors as a matter of law. Shareholders and LLC members have a form of asset protection called limited personal liability. Creditors cannot take owners’ personal assets to pay business debts, unless a business owner specifically gives up that limited liability protection.
Unfortunately, most small business owners are forced to give up their right to limited personal liability, at least for some of their business debt. Many creditors require personal guarantees and/or personal security from small business owners before they will loan money or extend credit to a business. And many landlords require a personal guarantee before they will lease commercial property to a small business.
A personal guarantee is a promise by a business owner to hand over the owner’s personal assets to a creditor if the business can’t pay its debt and its assets are not worth enough to cover the debt. A creditor can also ask a business owner to secure a business debt by pledging specific personal property, such as an owner’s house, boat, or car. When you sign a personal guarantee or pledge personal property, you give up your protection against personal liability, and creditors can come after your personal assets if your business can’t pay.
The Bankruptcy Option
If your business bank account is empty, a bankruptcy might be a viable option. It would certainly give you some breathing room while working things out, and in the case of personal liability, a bankruptcy will protect your house, your car, and other assets.
Business vs. Personal Bankruptcy
If you are a sole proprietor, you can file for either Chapter 13 or Chapter 7 bankruptcy. Either type of bankruptcy can be used for personal debts or business debts.
If you are a corporate shareholder, LLC owner, or partner in a partnership and you have signed personal guarantees or pledged collateral for business loans, putting your business through bankruptcy will not protect your personal property. If you have placed your personal property at risk, you must file for bankruptcy for yourself and your business separately to protect your personal assets. In this article, we assume you are considering personal bankruptcy — because only personal bankruptcy will protect your personal assets.
Chapter 7 vs. Chapter 13 Bankruptcy
If you file for personal bankruptcy, most likely it will be a Chapter 7 or Chapter 13 bankruptcy. In a Chapter 7 bankruptcy, your assets (except for property that is exempt which for the most part, usually includes your home, car etc.) go into a bankruptcy estate to be sold, and the proceeds are distributed to your creditors. At the end of the process, all of your debts that are eligible for discharge in bankruptcy will be wiped out. In a Chapter 13 bankruptcy, you propose a repayment plan where you repay part or all of the debt over three to five years.
How Bankruptcy Helps
When you file for bankruptcy, something called an automatic stay immediately stops your creditors from foreclosing on your house or any other personal property that is at risk. In some situations, this can be reason enough to file for bankruptcy, because it will buy you time, if nothing else.
Unpaid Rent. If your business owes your landlord back rent, you are probably personally liable for the debt. (Sole proprietors and partners are automatically personally liable for rent payments, and most small business corporations and LLCs also get stuck personally guaranteeing the lease payments — check your lease. If you didn’t, give yourself a pat on the back for being a savvy negotiator.)
Filing for bankruptcy might keep the landlord from taking your personal property to pay the debt, especially if you file under Chapter 13 and come up with a payment plan.
Ordinary, Unsecured Debt
If your business owes suppliers, you will be personally on the hook if you operated your business as a sole proprietorship or partnership. Under the Uniform Commercial Code, suppliers of goods usually have the right to take the goods back. Barring that, however, they can come after you personally for the unpaid amounts. If you have a lot of this kind of debt, filing Chapter 13 could help you organize a payment plan (and Chapter 7 might wipe the debt out).
If your business is a corporation or an LLC, you may be off the hook for these debts. This kind of debt is typically unsecured and is rarely personally guaranteed. If your business has no money and no assets left, the suppliers may be out of luck — your personal liability protection should protect your personal assets. So if your corporation or LLC has only unsecured, un-guaranteed business debt, there’s no need to file a personal bankruptcy.
Does Bankruptcy Make Sense for You?
In the real world, just the threat of bankruptcy may be enough to help you work things out. Many creditors will think twice before leaning on you too hard if they think you’ll file for bankruptcy. Some creditors would rather work out a payment plan, or settle for partial repayment, than become a creditor in your bankruptcy case. From a creditor’s perspective, bankruptcy is an expensive and long process that eats into profits. You can use that to your advantage in negotiations and perhaps spread payments out far enough to be manageable.
If you think you are in imminent danger of losing your family’s home or livelihood, and you need help quickly, personal bankruptcy might be a good option for you. But before you file, get advice, call the law offices of Paul M. Allen and take advantage of their free consultation. It could save you a lot of money and a lot of heartache. Paul Allen also offers debt nenotiation services and debt work-out plans.
Two convenient offices to serve you. Glendale 818-334-5445 or Cerritos 562-356-9931.
Law Offices of Paul M. Allen.
(This article is for information purposes only, and does not necessary reflect the company’s opinions and views on general issues. We make no warranty, prediction nor representation, nor do we assume any legal liability for the completeness of any information and its effect on any case. Each case is different and results depend on the facts of each case. Consult with and retain counsel of your own choice if you need legal advice.)