nfortunately, running a small business can be difficult, and sometimes businesses fail. Many small business owners that are struggling and look to bankruptcy as a tool to help them get out of debt. Many small business owners often wonder “Am I personally liable for the debts incurred because of my business?” To answer that question, we first need to define personal liability as it relates to bankruptcy.
Written by Attorney Karra Kingston.
Updated June 22, 2020
According to the U.S. Small Business Administration, there are nearly 30 million small businesses in the United States. Small businesses employ 47.8 %of the United States workforce. Small businesses have a huge impact on the nation’s economy. Unfortunately, running a small business can be difficult, and sometimes businesses fail. Many small business owners that are struggling and look to bankruptcy as a tool to help them get out of debt. Many small business owners often wonder “Am I personally liable for the debts incurred because of my business?”
To answer that question, we first need to define personal liability as it relates to bankruptcy. Personal liability in bankruptcy means that creditors can go not just after your business and its assets but after you and your personal assets if your business defaults on paying your business debt. Items that make up personal assets may be your income, home, car, etc. If you are personally liable for your business debts, then you will need to file a Chapter 7 personal bankruptcy to wipe away the debts of the business and any personal credit card debt or personal loans.
What kind of business owner are you?
Determining what type of business owner you are is important. Some businesses are set up as sole proprietorships or independent contractors who don’t have a separate legal entity.A sole proprietorship is a single owner business that is not incorporated and the owner is personally liable. An independent contractor is someone who works for someone else but is not an employee. Usually, an independent contractor provides some type of service. Both are considered self-employed.
If you’re a sole proprietor or an independent contractor you don’t have a separate legal entity and any debts that you have taken out from a bank or credit card are under your social security number and therefore are your personal debts. This is true even if the debt was incurred for the business.
If your business does not fall into one of these two categories, then your business may be an LLC, LLP, limited partnership, general partnership or a corporation. This corporate structure means that you have a separate legal entity. Thus, any personal loans or credit taken out may be under the business name or entity using an EIN number.
Once you’ve determined that your business entity, using its EIN number, rather than you personally, using your social security number, incurred the debt, it’s important to dig a little deeper. You may still be personally liable for the debt even though your business is the borrower.
Did you sign a personal guarantee?
It is important to look over the paperwork you signed when you took out your business debt and determine if you personally guaranteed any of the loans. Even if your business has a separate entity, as an extra layer of precaution, many lenders require you to personally guarantee the debt as a cosigner. If you personally guaranteed the debt, then both you and your business are jointly liable for the debt.
You may not have realized this when you signed the contract. A simple mistake like this can be costly if the business fails. When you look at the signature block on your purchase agreements, lines of credit, or service contracts for your business, an indication that you may be personally liable is if you signed your own name and didn’t sign it on behalf of the LLC.
Further, if you took out a home equity line to fund your business, the loan is secured by your real property (your home) and you’re personally liable.
If you find that you did personally guarantee your business contracts this means if you stop paying your lenders, creditors can go after you and your personal assets. If this happens, your creditors will start suing you. If a creditor gets a judgment against you in court they can garnish your wages, put a lien on your property, or levy your bank accounts.
Business debt exception to the means test
If all the debt is in your personal name, you may be able to obtain relief by filing Chapter 7 bankruptcy even if you’ve long since moved on from the business and are now employed and with a steady income.
Most individuals who file for Chapter 7 must pass a means test. The means test determines who is eligible for a Chapter 7. Congress implemented the means test to prevent individuals who could pay their debts, from getting their debt wiped away. Individuals who have primarily business debt are exempted from the means test. To qualify for the exemption, more than 50% of your total debt must have been incurred for a business purpose.
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What did you use the borrowed funds for?
Individuals often form a corporation or a limited liability company to limit their personal liability for their business debts. However, creating an entity does not get you out of being personally liable for personal debts. Some other ways that you can make yourself personally liable for your businesses’ debt aside from cosigning are:
Pledging your own property as collateral. Some lenders ask business owners to provide some sort of collateral before extending a loan. If you agree and pledge your real estate or other personal assets as collateral for the business loan, the creditor may be able to take the property and sell it to satisfy the debt.
Piercing the Corporate Veil. A creditor can go after your personal items by arguing that the limited liability protection of your corporation or LLC is not applicable. Courts will pierce the corporate veil and allow creditors to go after the personal assets of a business owner if they commingled money, certain owners had too much control over the LLC, or corporate formalities were not followed. If a creditor can show that the debt wasn’t incurred for the business, but rather for the owner’s personal benefit, they can ask the court to ignore the legal separation between the person and the entity. Thus, the person becomes personally liable even without actually guaranteeing the debt. Basically, you can’t use the borrowed money for personal items while at the same time saying you shouldn’t be personally liable for the debt because it’s in the name of the business.
Fraud. The last way that creditors can go after your personal items is if you committed fraud. If the business owner made fraudulent representations when applying for loans, they can be held personally liable for their actions.
Should I file bankruptcy for my business?
Deciding whether to file Chapter 7 bankruptcy for your business can be tough. If you decide to go this route, then you will need to shut down your business. When a corporation or an LLC files a Chapter 7 business bankruptcy, the owner's hand the business over to the trustee to liquidate and distribute any business assets. Any funds that are recovered from the sale of the liquidated assets are used to pay back creditors.
Once the trustee has liquidated all of the assets, and the proceeds have been paid out to business creditors, any creditors who were not paid any monies from the liquidation are out of luck. Corporations and LLCs don’t receive a bankruptcy discharge in a Chapter 7. Once a business entity does not exist anymore, creditors can’t collect from the company.
Most business owners who file Chapter 7 bankruptcy do so because the business has liabilities that exceed its assets. Thus, business owners usually receive nothing once the business is sold off.
Keep in mind that filing a business bankruptcy will not help you erase your personal liability if you co-signed any of the business debt. Even if your business debt is erased by filing a Chapter 7 business bankruptcy, you will still personally be on the hook. The only way to eliminate your personal liability for the debt is by filing a personal Chapter 7 bankruptcy.
Sometimes individuals shut their businesses down and only file a personal Chapter 7 bankruptcy. Business Chapter 7 bankruptcies can be expensive and if you are still going to be on the hook for the debts it may not be worth filing the business Chapter 7 bankruptcy. Instead, you may be able to close down your business and file a personal Chapter 7 bankruptcy. Although your business may still be on the hook for the debt, once your business is closed the creditors will have nothing to go after.
If you are unsure whether you should file a business bankruptcy, you may want to do some research. Speaking with a bankruptcy lawyer may be a good idea. A good bankruptcy lawyer can advise you about whether you should file a business bankruptcy by looking at your business structure and current financial situation. Many bankruptcy law firms give free consultations. Calling a bankruptcy attorney for a free consultation can be a good way to get some more insight into your situation and help you determine if a personal bankruptcy or a business bankruptcy is right for you.