If you are personally liable for some or all of your business’s debts, they can be wiped out by filing for Chapter 7 personal bankruptcy. On the other hand, if you are not personally liable for any business debts—for example, because your business is organized as a corporation or LLC and you have not voluntarily pledged your personal credit—you won’t need to file a Chapter 7 personal bankruptcy action for your business debts. Although your business might need to file its own business bankruptcy, that’s a different process (one that we don’t cover here).
To figure out whether you are personally liable for your business’s debts, you’ll need to start by looking at how your business is structured (as a sole proprietorship, partnership, corporation, or LLC). Even if you’ve formed a separate business structure that offers limited liability, you may still be responsible for its debts if you’ve personally guaranteed them or taken other actions that might put you on the hook, such as signing a lease or contract in your personal name rather than your capacity as a corporate officer, or pledging personal property as collateral for a business debt.
Sole Proprietorships and Partnerships
If you are the sole owner of your business, and you haven’t filed paperwork with your state to incorporate or form an LLC, you are a sole proprietor. The same is true for some businesses owned by a husband and a wife: If you live in a community property state, you and your spouse can run the business and still call it a sole proprietorship.
Legally, a sole proprietorship is inseparable from its owner; the business isn’t a separate entity that can take on its own debt. You are personally liable for every penny that your business can’t pay. If your business doesn’t have enough cash or assets to pay its debts, creditors can, and often will, go after your personal assets.
If you are a sole proprietor considering bankruptcy to get rid of your business debts, you need to file a personal bankruptcy, not a business bankruptcy. A personal bankruptcy will help you wipe out most types of debts, whether or not they are related to your business.
The same is true of general partnerships. In a general partnership, each partner is personally liable for 100% of the partnership’s debts. If there aren’t enough business assets to pay those debts, and your partners are broke, creditors can take your personal assets to pay all of the business’s debts, not just your pro rata share. But fortunately, filing a personal bankruptcy will get rid of all of your liability for the partnership’s debts, as well as any money you owe to your partners.
Corporation or LLC
If your business is organized as a corporation or LLC, you and your business are separate legal entities. You have limited liability for the business’s debts. In theory at least, this means you aren’t personally liable for the debts of your business, so creditors can’t take your house or other personal assets to pay business debts, even if your business can’t pay them.
Example: Cook’s Nook, Inc., orders kitchen supplies from 20 wholesalers before the business tanks. Unable to pay its expenses, the corporation closes its doors. Talia, the corporation’s sole owner, auctions off the store’s inventory and uses the proceeds to pay Cook’s Nook’s creditors, who receive a few cents on the dollar. She then dissolves the corporation by filing dissolution papers with the state. Because the business is a corporation, Talia is not personally responsible for paying any of Cook’s Nook Inc.’s remaining debt. Its creditors are simply out of luck.
Unfortunately for small business owners, legal theory is not necessarily legal reality. There are many ways corporate shareholders or LLC members can make themselves personally liable for business debts. In fact, most owners of small corporations and LLCs voluntarily take on personal liability for at least some business debts.
To learn about common ways an owner of a corporation or an LLC might become personally liable for a business’s debts, see When You Might Be Personally Liable for Corporate Debt.
Excerpted from Bankruptcy for Small Business Owners: How to File for Chapter 7, by Attorney Stephen Elias and Bethany K. Laurence, J.D.