When forming a small business, it is important to consider the impact that potential future debt could have on one’s personal finances. Specifically, the classification of a business can affect the degree of liability one has to settle business debt.
Debt is a large burden on a small business, but whether or not a creditor can pursue an owners personal assets depends on how the business is structured. The experienced small business advisors and attorneys at the Law Offices of Eldridge and Nachtman explain when an owner may be personally liable for debts accrued by a business.
What is the Risk?
Risk is inevitable when opening a business, but the risk associated with business debt has the potential to affect an owner’s personal life. If not protected under certain business structures, creditors can leverage an owners personal assets to settle debts accrued from their business. This can include seizing property, bank accounts and wages, among other possessions. If an owner is personally liable for a business, they stand to lose in the event that the business cannot pay its bills.
Structure Affects Liability
When building a business, an owner chooses which structure is best for the long term goals of the entity. However, the way a business is structured generally determines who is liable for that business’ debt.
Sole Proprietorships: When a business is operated as a sole proprietorship, or the owner is an independent contractor, the business and the individual who owns it are the same entity by law. This means that an owner is personally liable for all financial shortcomings of their business. Under this classification, a creditor has the ability to seize personal assets to settle debt and unpaid business expenses.
Partnerships: Similar to a sole proprietorship, businesses structured as partnerships do not produce security for personal assets. Each partner is equally liable for the debt of the partnership, regardless of ownership in the company. In the event that the business succumbs to a large amount of debt, and does not have the funds to alleviate the burden, each partner is liable to have their personal assets seized as compensation. If one partner is unable to support their share of the debt, the other will be held fully liable.
Corporations and Limited Liability Companies: Businesses structured as corporations and limited liability companies (LLC) are considered distinct legal entities from their owners—meaning there is generally no personal liability for debts accrued by the business. However there are exceptions to this rule. A shareholder, owner, or member of an LLC can be liable for certain business debts under the following conditions:
- Personal guarantees are used for business purposes: Often, a lender will not extend a line of credit or authorize a loan to a small corporation or LLC unless the owner signs a personal guarantee for the credit. In doing so, an owner is establishing that if the business does not pay the debt, they will be personally responsible for repayment. In terms of an LLC, an owner is reneging their limited liability by signing such a guarantee. It is important for owners to be aware of any personal guarantees on business expenses or contracts before signing off on them, as such can have long term effects on their own personal finances.
- Personal Collateral: Similar to guarantees, banks and lenders use collateral as insurance before providing small corporations and LLC’s with a loan or with credit. This is because lenders are aware of the legal separation of liability that an owner has from business debt. Due to this, a lender will sometimes require that an owner establish property as a form of collateral in the event that the business debt cannot be repaid. Should this happen, the owner’s property will be seized as repayment.
- Signing Contracts: When preparing agreements and contracts, it is important to be aware of the name which is presented on the legal document. The corporation or LLC name should always be present, as otherwise an owner’s signature on a contract could be construed as on behalf of themselves versus a signature on behalf of the company. When this happens, the owner can be held personally liable for any debt or payment.
- Personal Credit and Loans: Credit cards opened in an owners’ name, but for the use of a corporation or LLC are the sole responsibility of the owner. Similarly, loans taken out by an owner to secure the resources to open a corporation or LLC are the responsibility of that owner.
Regulation of Personal Involvement
In terms of securing loans on behalf of a business, regulations are strict. If it is discovered that an owner falsified or misrepresented business details when applying for funding, they can be held liable for debt that may ensue. Similarly if a court of law discovers that an owner did not maintain the proper degree of separation between personal and business transactions, further legal action could result.
ENLawyers Bottom Line
If you are found personally liable for a business debt, or you believe that you may be subject to liability for the same, you risk facing lawsuits from banks and creditors. In this event, there are options as to what you and your business can do to resolve the issue. For more information on small business debt liability or a free consultation about your situation, contact the experienced small business attorneys at the Law Offices of Eldridge and Nachtman by phone at 443.559.4384 or via email at email@example.com.