Worrying about whether a creditor can come after your personal assets to pay business debts is a common concern, and correctly so. In some cases, your personal bank account, wages, car, or even house might be up for grabs. It depends on the nature of the debt, your business's structure, and the state where you operate.
In This Article
Understanding Business Debts and Personal Liability
Business debts can include anything the company owes, such as loans, leases, trade credit (accounts payable), and lawsuit judgments. Being responsible for a business debt means that you're on the hook for it if your business fails to pay, and a lot can be at risk.
When Are You Liable for Your Business's Debts?
You're personally liable for your business debts under the following circumstances:
- You're a sole proprietor or a general partner in a partnership.
- You personally guaranteed the debt.
- You fail to make certain business tax payments.
- You don't maintain your corporation or LLC properly and lose its limited liability protection (the "veil" is "pierced").
What Actions Can a Creditor Take If You're Liable for a Business Debt?
Creditors can look to your nonexempt personal assets in collection or bankruptcy. In a bankruptcy case (and usually outside of bankruptcy), exemption laws determine what you can keep. (11 U.S.C. § 522.)
How Business Structure Affects Personal Liability
To determine whether your personal assets can be used to pay your business debts, the first thing you'll need to consider is your company's structure. For instance, liability differs depending on whether the company is a sole proprietorship, a limited liability company (LLC), a partnership, or a corporation.
Personal Liability by Business Entity Type
The more your business entity type separates you, the owner, from the business, the less likely it is that your personal assets can be used to pay your company's debts.
Unlimited Liability: Sole Proprietors
With a sole proprietorship, you and your business are legally the same, which is another way of saying that you personally owe every penny that your business can't pay. With a few exceptions, a creditor can reach your personal assets to pay debts your business owes.
However, you likely can use your state's property exemption statutes to protect the assets your state determines you need to maintain a home and employment. A sole proprietor who files for bankruptcy can eliminate both personal and business debt.
Unlimited Liability: General Partners
The same principle applies to general partnerships. The business debts belong to each partner personally, with this added twist: Each partner is personally liable for 100% of the business's debts, not just the share that represents each partner's ownership percentage.
If your partnership can't pay its debts, and your partners refuse or claim poverty (but you can cover the debt), a creditor can take your assets to pay off all the business debts. If you pay the entire debt, you can always sue your partners for reimbursement.
In a partnership bankruptcy, the trustee can also pursue general partners for any unpaid partnership debts. Because of the high risk of liability, partnerships generally don't file a Chapter 7 business bankruptcy, and most have a clause in the partnership agreement that disallows it. (11 U.S.C. § 723.)
Limited Liability: Corporations and LLCs
If your business is organized as a corporation or LLC, you and your business are separate legal entities. As a shareholder of a corporation or a member of an LLC, you aren't personally liable if your business can't pay its debts. In other words, you have LLC limited liability or corporate limited liability protection. You have this protection as long as:
- The debt is business-related, meaning that it was incurred by the business for legitimate business purposes. If you purchase an item for personal use through your company and you take on debt to make the purchase, you will be personally liable for the debt, and the creditor will be able to claim that asset if you fail to pay.
- The debt isn't secured by a personal guarantee or the pledge of personal assets as collateral.
- You haven't lost your corporate or LLC limited liability protection for one of the reasons stated below.
Secured vs. Unsecured Business Debt
Secured debt is a loan, line of credit, lease, or purchase you finance by agreeing that your property or other personal assets can be used as payment if you default. When a business takes out a loan, the lender will typically require a personal guarantee from the owners if the company isn't robust and financially secure. In this situation, the personal guarantee secures the loan.
An obligation made without such a condition is unsecured debt. This kind of debt isn't secured by a personal guarantee or collateral (property that you've pledged in exchange for the loan). If a business debt is unsecured, the creditor is out of luck if the business defaults. For this reason, most business debt is secured by a pledge of collateral or a personal guarantee.
Auto Loans: Secured Debts
If you've ever financed a car purchase at the dealership, you've taken on a secured loan. The loan agreement you signed gives you the ability to pay for the car in installments, and it provides the dealer with the right to repossess the vehicle if you fail to make the payments.
In this case, the car is what's called collateral. If you fail to make your payments, you can (and likely will) forfeit your vehicle. For more, see cars in Chapter 7 bankruptcy.
Debt Secured by Collateral
In addition to the property purchased serving as collateral, you can also secure a loan with property you already own. SBA lenders, for example, might require you to put up your house or other property as collateral to get a business loan.
If your business defaults on the loan, the bank can sue you to foreclose on the home (some states allow lenders to skip the lawsuit) or seize other property put up as collateral and use the proceeds of the sale to pay off the loan.
Debt Secured by a Personal Guarantee
When you're a small business owner, many creditors will require you to personally guarantee your business's debts. Banks might require you to cosign or personally guarantee a loan, and many leases require a personal guarantee.
Landlords typically require the owner of a new business to guarantee the lease personally. For example, if you sign a three-year office lease for your business and it includes a personal guarantee clause, you can be held personally liable for the rent for the duration of the lease if your business closes. Personal guarantees are less likely when the company is established, has a good credit history, and has solid assets.
Secured and Unsecured Credit Card Charges
Most credit cards are technically unsecured because you don't have to pledge your property to get one. However, some retailers take a possessory interest in the financed item, making it a secured purchase. This is common with jewelry, electronics, and furniture.
Also, a creditor can convert an unsecured credit card debt into a money judgment by taking you to court. A money judgment allows the creditor to seize the judgment debtor's property.
Below, you'll find more about how your personal assets can be used to repay your business's credit card debt.
When Business Owners Lose Limited Liability Protection
Liability-shielding rules don't protect you from wrongdoing. For instance, owners of an LLC or corporation can't use their business to buy items unrelated to the business. In these situations, creditors can reach the owner's personal assets, a practice known as "piercing the corporate veil."
Here are some exceptions to limited liability faced by all business types.
The Business Doesn't Pay Employee Withholding Taxes
If your business has employees, you must withhold taxes from their paychecks and send those taxes to the state and IRS. If your business doesn't follow the necessary procedures for paying withholding taxes, you, as the owner, are personally liable for the payment regardless of the type of business entity you have.
State Rules Override Limited Liability
Each state sets its own rules for corporations and LLCs, including liability exceptions. Some states are considered creditor-friendly, while others are considered debtor-friendly, depending on how their laws are written and interpreted by the courts.
States can amend their rules through legislation and court rulings, so it's essential to stay up to date on changes.
You Signed a Contract Using Only Your Own Name
Of course, your business can't physically sign a contract or purchase agreement, and you, as the owner, must sign on behalf of the company. But you can jeopardize your limited liability if you enter a contract using only your name and fail to include your business name and your relationship to the business in the contract.
Example. Imagine you're the owner and CEO of Glam Footwear, an LLC that operates a small chain of shoe stores. You place a large purchase order for the fall season and fail to review the purchase agreement carefully. The agreement starts with, "Purchase agreement between Jane Smith and Shoe Importers, Inc." The contract should say that it is "between Glam Footwear, LLC and Shoe Importers, Inc." You sign the agreement as "Jane Smith" instead of "Jane Smith, CEO of Glam Footwear, LLC."
Example. Assume the facts as above, but Glam Footwear's business drops dramatically in the summer. By the time the shoe shipment arrives, the company's cash flow is depleted to the point that it can't pay for the fall merchandise shipment. The way you entered into and signed the purchase agreement could make you, Jane Smith, responsible for paying the invoice, even though your company's structure provides limited liability.
Your Corporate Veil Has Been Pierced
Creditors can hold you personally responsible for your business's debts if your corporation or LLC doesn't follow the rules established by your state for that business entity. Again, this situation is known as "piercing the corporate veil." Some examples are:
- The corporation fails to hold annual meetings and keep minutes documenting important decisions as required by law.
- LLC members pay their personal bills using the LLC checkbook, or they pay LLC bills out of their personal checkbook.
- A corporate shareholder or LLC member misrepresents or lies on an application for a loan or credit on behalf of the company.
- An LLC member or shareholder commits a criminal act, such as being convicted of stealing money from the company.
When a creditor can show that any of these types of criminal activity, fraud, misrepresentation, or sloppy recordkeeping occurred, a court can decide that your business entity is really just a sham, meaning that you don't have limited liability.
Can Creditors Use Business Assets for Personal Debts?
Generally, the same rules apply. If you're an owner of a corporation or LLC, you're a separate entity from the business, and the business isn't responsible for your personal debts.
A creditor with a court judgment against you can take any property you own, including money owed to you by the LLC, and your interest in the LLC itself. For the same reason, a creditor with a judgment against a corporate shareholder could end up owning corporate stock.
What a creditor will be able to recover with a court judgment will depend on your state laws. You should contact a local business lawyer to assess your liability.