Are Shareholders Liable For A Default On An Sba Loan[yoast-breadcrumb]
Are Shareholders Liable For A Default On An SBA Loan?
When a small business defaults on a loan from the U.S. Small Business Administration (SBA), the consequences can be severe. The SBA has the power to seize assets, garnish wages, and take other aggressive collection actions to recoup taxpayer dollars lent to the business.
This leads to the natural question – if the business itself cannot repay the loan, can the SBA go after the personal assets of the business’s shareholders? Do owners, investors, and partners risk losing their houses, retirement savings, or other individual wealth if the company defaults?
The short answer is, it depends on the legal structure of the business. For some entities like sole proprietorships and partnerships, the shareholders do not have legal separation from the company, so their personal assets are exposed. But for corporations and limited liability companies (LLCs), shareholders generally have legal protections.
Let’s take a closer look at how SBA loan liability works for different legal structures:
A sole proprietorship is the simplest business structure, with no legal distinction between the business owner and the company itself. The owner reports all income and losses on their personal tax return.
If a sole proprietor defaults on an SBA loan, their personal assets – bank accounts, home, vehicles, etc. – can be seized by the SBA to satisfy the debt. The business owner has unlimited personal liability.
In a general partnership, two or more owners share management and liability. Like sole proprietors, general partners can be held personally responsible by the SBA for repayment of a defaulted loan.
For limited partnerships (LPs), liability depends on partner status:
- General partners have unlimited personal liability like sole proprietors.
- Limited partners have liability limited to their investment in the business.
So in an LP default, the SBA could pursue general partners’ personal assets but usually not limited partners’ assets.
A C-corp provides the strongest shield between business and personal liability. Shareholders are not personally responsible for the corporation’s debts and liabilities.
However, the SBA requires personal guarantees from owners with 20%+ ownership when lending to C-corps. This guarantee gives the SBA recourse to pursue these shareholders’ personal assets in a default.
Minority owners with less than 20% ownership generally have no personal liability for an SBA loan default.
S-corps provide business liability protection like C-corps. Owners are not automatically liable for company debts.
But S-corp owners must guarantee SBA loans personally. So all shareholders face potential personal liability if the S-corp defaults on an SBA loan.
Limited Liability Companies (LLCs)
LLCs limit owners’ liability similar to corporations. Personal assets are generally protected from company debts and liabilities.
For SBA lending, the same rules apply to LLCs as C-corps. Members with 20%+ ownership must provide personal guarantees, while minority members have no liability.
In some cases, the SBA may attempt to “pierce the corporate veil” to hold shareholders personally liable despite legal protections. This may occur if:
- The corporation is undercapitalized.
- Company funds are commingled with personal funds.
- The company fails to follow legal formalities.
- Fraud or misrepresentation is involved.
Veil piercing cases are fact specific, but limited liability protections can be lost if shareholders abuse the corporate structure.
What About Co-Signers?
For any type of business, the SBA often requires owners to provide a co-signer, or guarantor for loans. This person agrees to be personally responsible if the business defaults.
Having a creditworthy co-signer reduces the SBA’s risk, so they may approve a loan they would otherwise deny. But it exposes the co-signer to personal liability.
What Happens in a Default?
If an SBA loan defaults, the SBA can take legal action to collect against all available sources:
- Business assets and accounts.
- Personal assets of owners who guaranteed the loan.
- Assets of any co-signers or guarantors.
Collection methods can include wage garnishment, bank account levies, property liens, and asset seizures. The SBA may also refer cases to the Treasury for tax refund offset.
Avoiding Personal Liability
If you want to protect personal assets when borrowing an SBA loan, incorporate as a C-corp or LLC. Also:
- Properly capitalize the business.
- Follow legal formalities and document meetings.
- Keep business and personal finances completely separate.
- Avoid co-mingling funds or personal use of company assets.
- Maintain adequate business insurance.
Piercing the corporate veil is less likely if you respect corporate structure. An attorney can provide guidance on protecting yourself.
Seeking Loan Forgiveness
If your business defaults, consider applying to the SBA for discharge or forgiveness of the loan. This can cancel your liability. Grounds may include:
- Undue hardship
- Death of the borrower
The SBA may forgive all or part of a loan if you demonstrate an inability to repay. This can protect personal assets even after a default.
- Sole proprietors and general partners have unlimited personal liability for SBA loans.
- Corporations and LLCs protect shareholders, except majority owners who must guarantee.
- Co-signers and guarantors also face personal liability if the business defaults.
- Work with an attorney to structure your business to limit liability exposure.
Are Shareholders Liable For A Default On An SBA Loan?
When a corporation or LLC defaults on an SBA-backed loan, creditors will look for repayment sources like company assets and owner guarantees. But can they go after shareholders who weren’t direct loan guarantors? Generally no, but there are some exceptions. Here is an overview of shareholder liability risks with an SBA loan default.
Limited Liability Protection
A key benefit of the corporate structure is limited liability for shareholders. The corporation is responsible for its debts – not owners or investors. So if an SBA-backed loan goes into default, shareholders are normally shielded from collection actions or lawsuits.
LLCs also provide owner liability protection, treating members like corporate shareholders unless they personally guaranteed the loan.
However, SBA loans commonly require one or more owner guarantees. These make specified individuals personally responsible for loan repayment. If those guarantors are also shareholders, their liability protection does not apply to the guaranteed debt.
The loan guarantors remain completely exposed to collection and legal actions in case of default, regardless of shareholder status.
Piercing the Corporate Veil
While rare, creditors can sometimes “pierce the corporate veil” to hold otherwise protected shareholders liable for company debts.
This involves proving shareholders abused the corporate form for wrongful purposes, like fraud, self-dealing or gross undercapitalization. It tears down the liability shield.
Alter Ego Theory
Similarly, under the “alter ego” theory, courts may disregard the corporation as a separate entity from owners. This makes otherwise insulated shareholders jointly responsible for liabilities.
But piercing the veil or applying the alter ego doctrine is quite challenging. Creditors must prove extreme shareholder misconduct.
Majority shareholders or those exerting significant company control also have slightly higher liability risks. Courts are more willing to check limited liability protections for dominant shareholders in the interest of fairness.
But control alone does not justify holding shareholders liable for a company’s defaulted SBA loan.
State laws vary on shareholder liability concepts like veil piercing and alter ego theory. For example, California makes it easier to prove alter ego than New York. So location matters.
An experienced business attorney can explain risks under your particular state laws if a shareholder-owned company defaults on SBA financing.
If the company files bankruptcy after an SBA loan default, shareholder liability depends on the specific chapter.
Chapter 7 liquidation does not impose liability risks for shareholders.
But under Chapter 11 reorganization, shareholders could be compelled to contribute funds to the restructuring plan using company equity.
If shareholders engaged in conduct amounting to negligence that contributed to the SBA loan default, liability is possible. This could include failing to provide promised capital, mismanaging funds or ousting owner-guarantors.
But negligence must be proven based on shareholder acts, not merely their status.
From a tax perspective, shareholders cannot directly write off corporate debt. But an SBA loan default decreasing corporate assets can reduce the stock value and shareholders’ equity.
This may provide indirect tax deduction benefits to shareholders.
Talk to Counsel
If your company defaults on an SBA loan, talk to an attorney about any potential risks facing shareholders. While liability exposures are limited, it’s wise to understand vulnerabilities.
With proper legal guidance, shareholders can continue to rely on their limited liability protection.