Which business debts should I pay first to avoid personal liability?

When a business can’t pay all its bills, most owners are sure they know the answer: pay the suppliers and the others who are needed to keep the business operating, defer those who are more forgiving about getting paid.

A little closer analysis will cause the list to change: Pay the taxing agencies and those who have a personal guaranty to back up the business’ debts. For those two debts, default can land on you personally, so the consequences are different. Your decision on what to pay has to be based on whether you can get the company through. So ask yourself this: Are you able to lead the company through this?

The Taxes That Can Make You Personally Liable

A corporation or LLC does not shield you from some unpaid taxes. Why does this surprise you? Most owners assume that their corporation or LLC or whatever protects them. The IRS and state revenue departments are often the last creditors to call, so owners forget they can be personally liable. Any company officers or employees, including a bookkeeper that decides which bills get paid, can be liable. Be careful that you aren’t one of these people.

The taxes that do create personal liability include sales tax, use tax, and federal payroll taxes. Sales tax is the tax you collect for the state, not the business. To the state, this money belongs to them. They can get very upset if you don’t pay it, and can call the failure to send it in “conversion” or “theft” by the business. It is money that is held in trust even though mixed with company money. If the business collects sales tax and doesn’t turn it over, it’s owed to the state and has always been owed to the state.

Federal payroll tax is split into two parts: what’s withheld from your employees wages, and your contribution. The IRS treats the withheld amount as the employee’s money. Unpaid sales and payroll tax will continue to rack up penalties and interest, including interest on the penalties, and can quickly become greater than the original tax. And the tax problems never really disappear.

Just because the state or IRS may wait a year or more to collect, does not mean that the penalties and interest stop adding up. If you can only pay part of your payroll tax, designate the payment to the employee withholding part. The employer’s portion is not usually a personal liability, just the typical business debt.

Bottom line for taxes: pay sales or use tax and payroll tax over everyone else whether you intend to continue in business or not. If you are planning to shut the business down, those tax debts may still come along for the ride.

Personal Guaranties

Business vendors often require personal guaranties from the owner of a new business. Banks almost always need a guaranty on a business loan. This means that if the business can’t pay, they can go after you personally. They might have you guaranty it with your home or other property. Some of these you may have forgotten you signed, but your creditors have elephant-sized memories, and they never forget.

Before discarding an old debt, especially any related to a loan, check for a personal guaranty. Pull out the loan documents and remind yourself who has to pay the loan back if the business isn’t able to make the payment. Don’t rely on memory. If it is iffy that the business will make it, then pay the guaranty creditors; if you are closing down, offer payment for release of the guaranty.

Can Your Business Realistically Survive

Before you decide whom to pay, be honest with yourself - can your business realistically survive? Can your health survive the pressure? Decide whom to pay after honestly answering these questions, not before.

This is a time where what seems self-evident is often anything but. When facing this kind of mental pressure, it can be hard to see the forest for the trees. The psychological stress of the situation tends to block clear thinking, but the advice of experienced financial or legal professionals can confirm you have reason to carry on, or save you regret if the company has to close.

One option is chapter 11, but it is not right for all businesses. If your otherwise profitable business has hit a one-time, uninsured wall, a chapter 11 may help. It stops creditors from filing collection suits and, in some cases, collection actions on guaranties against the owner of the business. It’s a difficult and expensive process, so get sound legal advice.

Many businesses choose to close without filing bankruptcy, for example, they sell off assets to pay creditors and close down. In this instance, the creditors with liens get paid off first, then everyone else gets what’s left. Sometimes a business owner thinks “We’re almost dead, so let’s keep the doors open a few more weeks so I can get a paycheck.” This is almost always a bad idea. Taxes and guaranties can outlive the company. Go to a professional for advice as soon as possible, while you can still make a difference.