If you own an LLC or a corporation, you probably formed it so the company’s debts would stay the company’s debts. That shield is real, but it is not absolute. At Delancey Street, the owners we talk to are often surprised to learn that business bankruptcy can expose them to personal liability. In this post, we’ll describe the seven ways this can happen. If the business debt is your personal debt, filing business bankruptcy won’t help you. You’ll need to file personal bankruptcy.
Personal Liability for a Business Debt
The first is the personal guarantee. The promise to cover a company’s debt if the company can’t pay it back is known as a “personal guarantee.” If you signed a personal guarantee, the lender can come after you if the company defaults, no matter that the business is an LLC or a corporation. In other words, if your business doesn’t pay the debt, you will. Suppliers, banks and landlords know that owners aren’t normally liable for business debts, so they often demand that you guarantee the debt before they will do business with the company. Plenty of owners sign anyway, even though limiting their liability was the point of forming the company. They want the loan. They think they have no other choice. If you aren’t sure whether you signed one, check your vehicle and equipment loans, your trade terms with suppliers, your bank line of credit and the fine print on a lease agreement, for example. Also read through every financial agreement you have signed, and look for a personal guarantee clause.
The second way is pledging personal property, such as your home, a boat or a car, as collateral for a business loan. Banks often require an owner to put up real or personal property as security for the loan. If the business defaults, the bank can try to foreclose the house to recover the money. Here is the part that catches people off guard. If you “pledged” your house as collateral to obtain the business loan, Chapter 7 discharges your personal liability, but the lien survives the bankruptcy, so you still must pay off the loan to keep or sell the house.
Third, remember that when you sign a contract, it matters in what capacity you sign it. If you signed a purchase agreement or service contract in your own name, even if it was an innocent mistake, you could be liable for it personally. Check the signature block on the agreement to see if you signed in an individual capacity or as an officer of the LLC.
Fourth, personal credit cards and home equity loans. A lot of owners have kept the doors open by putting business costs on a personal card or borrowing against the house, and that’s exactly the problem. It’s devastatingly easy to use them to finance the business until there’s no cash left. If you used your personal credit cards to pay for business expenses, those are likely your personal debts. Even credit cards opened under a business name typically have clauses in the agreement making the individual applicant responsible for all the payments made with the card. You can file Chapter 7 in your own name, and qualifying debts - including credit card balances and home equity loan deficiencies - can be discharged.
Fifth, a tort. A tort is a wrongful act that harms another person and causes a monetary loss. If an owner personally commits one, the owner can be held liable personally, meaning that he or she is responsible for the loss himself or herself. The company’s LLC or corporate status doesn’t change that. Not every bad business decision is grounds to hold an owner personally liable. Owners generally aren’t on the hook for management decisions or ordinary mistakes; the liability attaches to your own wrongful conduct.
Sixth, fraud. Lying on a loan application can expose you to full personal liability for a business debt. The bad news is that if you file bankruptcy to get out of trouble after lying on the loan application, it generally won’t help, because debts that arise because of fraud are excepted from discharge.
Seventh, piercing the corporate veil. You do not need to have committed fraud to have the veil pierced. Creditors can ask a court to hold you personally responsible for business debts if it finds that a business owner’s limited liability company (LLC) is not a true, separate business entity and therefore the owner should be personally responsible for the company’s debts and obligations. When the corporate veil is pierced, a business is treated as if it does not exist, and its owner’s personal finances are liable for the company’s debts. Creditors will most often look for lack of evidence of meetings or resolutions on major business decisions. Next are commingling of funds (moving money between personal and business accounts) or treating your business as an alter ego (using your business as your personal wallet). Even if you’re the only owner or you’re married and run an LLC together, you still need to follow the formalities. Basically, you maintain a certain level of corporate formalities and you treat the corporation/LLC as separate from yourself.
What Chapter to File Under
If any of this sounds familiar, personal bankruptcy is the tool, and what chapter to file under will depend on your income level, your assets and whether you’re planning to keep your company open. Chapter 7 liquidates all of your nonexempt assets, discharges most qualifying unsecured debts (the parts that can’t be wiped out are called nondischargeable debts), and typically takes 3 to 6 months. You cannot catch up on secured debts (e.g., arrears on a mortgage). Chapter 13 lets you repay your personal debts in a 3- to 5-year repayment plan. This can help if you have secured debts on collateral you want to keep.
Bankruptcy Attorney
The first step would be to sit down with a bankruptcy attorney and go over every contract and loan document you signed, looking for personal guarantees and checking whether you signed as an individual or in a representative capacity. A bankruptcy attorney can also advise whether your debts are dischargeable in bankruptcy, for example if they are fraud-based they may not be, and can advise which bankruptcy chapter would be appropriate for you.
Delancey Street is not a law firm. When bankruptcy is the better path, we say so on the first call and refer owners to a vetted independent attorney. When it isn’t, our senior advisors negotiate with merchant cash advance funders and lenders for less than the full balance owed. The first consultation is free and confidential.
