When you close your business, you may worry that your creditors are going to come after your personal assets like your home, savings and even your children’s college fund. You may fear you will still owe them long after the doors close, and that those same creditors will decide to press the issue. These concerns aren’t always unfounded. Whether you end up liable turns on a few things, chiefly the legal structure of your business and whether you signed any personal guarantees on the debts. What you should know is that your personal assets are not automatically a target for creditors. When you sign a personal guarantee for your business debt, you are leaving yourself vulnerable to these situations.
If you run a sole proprietorship and never created a separate legal entity, you carry the most risk. Any business creditor can go after your personal assets as well as the company’s, and you can be sued for any of your debts, and you can be held personally responsible for them. That can lead to judgments, liens and collection attempts. In practice it means that anything you get in debt to create the business is your personal liability, and so is anything the business takes on when it operates.
In a partnership, there is an agreement between two or more people to operate a business together. Your liability depends on how the partnership was formed. In a general partnership, all partners are personally liable for the company’s debts. If it is a general partnership or a sole proprietorship, then you don’t need to worry about a personal guarantee because everyone is already on the hook. In a limited partnership, only the general partner has unlimited personal liability. The limited partners are not liable for any debts of the partnership. Limited liability partnerships are trickier. It depends on the state you are in. Some states say no partners have personal liability. Others say partners are personally liable for contracts. Some states require the partnership to have a general partner, so the general partner has personal liability. And in some states, partners are only shielded from negligence claims but not from other debts. If you are a partner in an LLP, you need to check the law of the state where it was formed to see if you have personal liability.
An LLC is built to protect its owners. The IRS recognizes an LLC as a “pass-through” entity, so a member reports business income on his or her personal income tax return. The act of filing with the state creates a separate entity, however, and the members are protected from the company’s liabilities. You create a wall of separation between your personal finances and the business’s finances. This means that since the business is a separate legal entity, its debts remain the responsibility of the company, not you personally. The same is true with shareholders of S and C corporations and members of the board of directors. While incorporating can protect shareholders from the effects of business debt, it’s not a “get out of jail free” card.
Limited Liability Can Be Sacrificed
The protection has two weak points. The first is commingling. Limited liability only exists if you use your corporation correctly. When you don’t treat the company as a separate entity, the court can pierce the corporate veil and hold you personally liable. If the members of an LLC or the shareholders of a corporation are thought to be blurring the line between business and personal finances, the courts may dissolve the veil separating the company from its owners. Even if you are the only member of your LLC, you need a separate bank account and separate records. Don’t deposit business income into your personal bank account. Don’t pay personal expenses with a check from the business bank account. Take the time to create separation between business and personal finances.
The other way that limited liability can be sacrificed is if members of an LLC or shareholders of a corporation have given personal guarantees of the company’s obligations. By signing personal guarantees, members or shareholders are voluntarily assuming liability for the company’s debts. It is not uncommon for small business entrepreneurs to sign personal guarantees when they start a business. When a business owner signs a personal guarantee, the business’ debts become their own. If the business can’t pay its debts, the personal guarantor must pay. The guarantee also allows a creditor to collect from the business owner’s assets in the event of a default or insolvency. In most cases, if you signed personal guarantees you are responsible for paying the business debt after you close a company. When you have personal guarantees, the outstanding debt is your problem. This is true whether you closed the business or not. An obvious choice would be to just walk away and see what happens. This is not a good idea. Creditors can sue you personally for any obligations covered by a personal guarantee.
One more trap has nothing to do with structure. Regardless of how your business is organized, if you don’t pay your payroll taxes, the IRS can hold you personally responsible. Internal Revenue Code section 6672 holds “responsible persons” liable for payroll taxes. This includes officers, directors, accountants and others. They’re on the hook for penalties and interest too. If you are dealing with the government, don’t expect that the debt goes away with the company. Check your corporate credit cards as well, such as Brex or Ramp cards. If they carry a personal guarantee, you are liable for that debt too, and if they are unpaid, they could become a liability against you once the business is closed.
If the business cannot pay what it owes, you can negotiate with creditors, set up an assignment for the benefit of creditors (ABC), file for bankruptcy, or close the business. The right choice depends on the nature of the creditors and amounts due to them, whether business assets remain available to pay your debts, whether you have previously provided personal guarantees to secure your business debts and the impact of the various options on your personal finances. Whatever you choose, be aware that filing for bankruptcy, ABCs and closing businesses are all choices that will have a profound effect on your personal and professional life, and should not be taken lightly. One caution: if any of the business’ debts is supported by a personal guarantee from an officer, shareholder or owner, the person liable on that debt is not free until the debt is satisfied. When you negotiate with creditors, talk to them about the possibility of taking your personal guaranties out of the equation and entering into a restructuring of your debts.
Before you close the doors for good, pull out every loan agreement, lease and credit card agreement you signed, and find out if you guaranteed any of the debts your business owes. Personal guarantees on credit cards, loans and leases put your personal assets in jeopardy. Failure to understand personal guarantees can have disastrous consequences for the owner when the time comes to dissolve the business. If your company is an LLC or corporation, you kept its money separate from yours, your payroll taxes are paid and you signed no guarantees, your personal assets aren’t automatically at risk. It is entirely possible to close the doors without damaging your personal finances. If you have business debt with personal guarantees, closing the business will not take them with it. Those guarantors are still responsible for those debts, so find a way to negotiate, restructure, or otherwise resolve them.
