Several factors—your business structure, the type of debt, and the state where you operate—determine whether creditors can reach into your own pocket to pay off debts your business owes.
Some business entity types provide greater protection for your personal assets than others. Here's how personal liability breaks down for each business structure:
Limited liability companies (LLCs) and corporations. When your business is structured as an LLC or a corporation, the law views it as a separate entity from you, the owner. Likewise, your business debt is separate from your personal finances, and it's less likely that creditors can take your personal assets to pay off your business's debts.
Sole proprietorships and general partnerships. With these structures, the business and owner are one and the same in the eyes of the law. You can be held personally liable for every dime your business owes, and conversely, a creditor can come after your business to make good on personal debts you owe.
You might face an added wrinkle when your business is structured as a partnership. In a general partnership structure, each of the partners, regardless of their ownership share in the business, bears responsibility for all of the business's debts. If your business is unable to pay a debt, and your partners can't or won't pay it, but you have the means to cover it, a creditor can take your assets to pay the full amount of the debt. (You could sue the partners who wouldn't or couldn't pay to recoup your money, but doing so would likely spell the end of your business relationship.)
Limited partnerships. In a limited partnership structure, (these entities consist of at least one general partner and one limited partner), only the general partners are personally liable for the business's debts. Creditors can take the personal assets of a general partner, but can't use the personal assets of the limited partners to pay the business debt.
While LLCs and corporations limit your personal liability, don't expect this protection to apply in every case. Here are some situations when structuring your business as an LLC or a corporation won't protect your personal assets:
When the debt isn't business related. You can't escape personal liability for a debt just because the debt was incurred by the business. Let's say your LLC buys a beach condo that has no connection to the work your business performs. If the business fails to make payments on the condo loan, you can be held personally liable for the debt.
When you don't pay employee withholding taxes. Business owners, regardless of their entity type, are responsible for collecting withholding taxes from employees' paychecks, and they can be held personally liable if the business fails to send the required withholding taxes to the state and the IRS.
When you've signed a contract or agreement using only your own name. You won't be able to preserve your limited liability for debts owed under a contract or agreement that you signed using only your own name. The contract must include the name of the company and your relationship to it in order to establish that the business (and not you) is the debtor.
When you've provided a personal guarantee for a loan that is taken out by the business. Many lenders will not do business with LLCs or corporations that are new, unproven, with a history of late payments, or thinly financed. The lenders worry, naturally, that the liability protection enjoyed by the LLC or corporation will mean that the bank will be out of luck if the business defaults. So, they require the owner to provide a personal guarantee, which is exactly what the owner meant to avoid when setting up the LLC or corporation! You might be able to eventually get out from under this threat as your business grows and you develop a pattern of being able to pay your bills.
When you don't follow your state's rules for an LLC or a corporation. You might jeopardize your limited liability if your business fails to follow the rules set by the state.
Some of the ways members of an LLC or shareholders in a corporation might put their personal liability at risk include:
Under a theory referred to as "piercing the corporate veil," creditors can use rule infractions and crimes like those listed above to show that the business isn't really being run or treated as a separate entity from the owners, and courts might find that the personal assets of LLC members and corporate shareholders may be used to satisfy business debts.
It's a good idea to stay current on the rules and regulations for LLCs and corporations in your state, because court rulings can result in changes to the way they are written or interpreted.
You can be held personally liable for your business debts if the business takes out a loan, line of credit, or finances a purchase and you agree that your personal assets can be used as payment if your business defaults. (This situation is similar to providing a personal guarantee, as explained above.)
In these types of credit arrangements, known as secured debt, creditors can require a business owner to use collateral (business property such as equipment, or personal property, such as your home), in order to get a loan.
For example, banks might require you to pledge your home in order to get a business loan. If your business fails to make the loan payments, the bank would be able to sue you to foreclose on your home and use the sale proceeds to pay off the loan. (Some states allow lenders to skip the lawsuit.)
Personal guarantees and sales or loans secured by real property are often used in real estate transactions and purchase agreements that require monthly payments. Let's say a business owner personally guarantees a lease for restaurant space. If the business closes before the end of the lease, the business owner would be on the hook for paying the rent for the duration of the lease.
Lenders and creditors like landlords often require collateral or personal guarantees when a business has no credit history, isn't financially sound, or has few assets.
All credit card companies require a personal guarantee that's typically spelled out in the terms and conditions of the application. When you apply for a credit card for your business, you must agree that you, the business owner, and the company are jointly responsible for paying the charges. It doesn't matter whether you use the credit card to buy business supplies or to fund your business. You'll have to pay for the credit card charges if your business can't.
Corporate credit cards are the exception. However, only well-established businesses with sound finances and a long credit history are eligible for corporate credit cards.
You can discharge some of your business's debt by filing bankruptcy, but how much relief you get depends on your business entity type, the type of debt, and the type of bankruptcy case you file.
The most common types of bankruptcy filings are Chapter 7, Chapter 11, and Chapter 13 (read on for the definitions of each). Federal bankruptcy court sets the rules for each, and states might impose additional requirements.
Filing bankruptcy won't relieve the owners of sole proprietorships or general partnerships of their business's debt, because the owners of these business entities are personally responsible for all debts the business owes.
The owners of these business entities might consider filing for personal bankruptcy under Chapter 7. In a Chapter 7 bankruptcy, a trustee is appointed to sell off the debtor's assets and distribute the proceeds to repay creditors.
The courts use a means test to evaluate whether your income, expenses and other factors qualify you to file Chapter 7. Although state laws vary, most usually exempt certain property (such as home equity, furnishings, vehicles, and a portion of wages) from sale.
Chapter 13 bankruptcy is another option for sole proprietorships and general partnerships unable to meet their debt obligations. In a Chapter 13 bankruptcy, the debtor repays creditors in monthly installments over a period of three to five years. (Creditors and the court must approve the repayment plan.)
Businesses can't use Chapter 13 bankruptcy filings, but if your sole proprietorship or general partnership has run up more debt than it can pay, the owner can use Chapter 13 for both secured and unsecured debt.
If your company is structured as an LLC or a corporation, you'll be able to discharge some of the debts your business owes by filing bankruptcy, but you'll still be on the hook for repaying loans or other debts you've secured with personal assets or a personal guarantee.
LLCs and corporations can use Chapter 7 or Chapter 11 to file bankruptcy. In a Chapter 11 bankruptcy, the business owner works out a repayment plan with creditors while continuing to run the business. A majority of creditors and the court must approve the plan.
The short answer to this question is ‘Yes' for sole proprietorships and general partnerships, and ‘No' for LLCs and corporations, but the devil is in the details. Here's how it breaks down:
Sole proprietorships and general partnerships. These entities aren't separate from their individual owners, and creditors can take business assets to pay off an owner's personal debt.
LLCs. Conversely, the assets of an LLC can't be used to pay off a member's personal debts because an LLC is a separate entity from its members. However, let's say the member receives profit distributions from the LLC. A court can order the LLC to pay those monies to a creditor to satisfy the member's personal debt, because those distributions are considered personal assets. In these cases, a court can issue a "charging order" that directs the LLC to pay those funds to the creditor instead of the member.
Most states will not allow creditors to take a member's ownership stake in the LLC or force a sale of the company to repay personal debt. But single-member LLCs don't always have the same protections.
Single-Member LLCs (SMLLCs). Some states will ignore the LLC shield and allow a creditor to take control of the company or force a sale of a SMLLC. The reason for treating single-member and multi-member LLCs differently is that while it wouldn't be fair to make individual members of a multi-member LLC pay for the personal debts of one member, the business assets of a SMLLC are fair game because the one member is the only one affected.
Likewise, a bankruptcy court might tap the assets of a SMLLC to pay the member's personal debts.
Corporate shareholders. A creditor with a judgment against a corporate shareholder can also take a shareholder's stock shares to satisfy a business debt, because those shares are considered personal assets. If the shareholder holds a large enough stake in the company, and the debt is large enough, a creditor in this case could potentially end up controlling the company or force its liquidation.