For the small business owner who owes a lot of money but can't pay, creditors may threaten legal action against the entrepreneur personally. How much creditors collect, and how creditors can go about collecting debts, depends on how an owner organizes the business, whether the entrepreneur personally guarantees repayment of debts, and whether a business owner files for bankruptcy.

Personal Liability and Business Structure

When financial problems threaten business survival, the first step in determining whether to file bankruptcy is to evaluate potential personal liability. The extent of a small business owner’s personal liability depends on how s/he structures the business and whether the owner personally guarantees or secures any debts. A business does not need to file bankruptcy to go out of business. It can liquidate assets and cease operations. Creditors may recover claims from the assets of the business, but if there are no assets, the creditors can file collections lawsuits against the business or the owner.

Sole Proprietor

For a sole proprietor, the owner and the business are one. This means the owner is personally responsible for all of the business's debts. If there isn't enough money in the business to pay these debts, creditors can take the owner’s personal assets to pay them.

Partnership

A partnership is two or more persons associating as co-owners of a business for profit. No writing is necessary to form a partnership. Partners are jointly and severally liable for all partnership obligations when a partnership is not a limited liability partnership. A limited liability partnership shields each party from individual liability for the acts of other partners. A partnership may become a limited liability partnership by filing a statement of qualification with the Secretary of State. The registration notifies third parties their sources for recovery of losses is limited. When limited liability partnership formation requirements are not met, a partnership is a general partnership by default.

Partners in a general partnership have personal liability similar to a sole proprietor for business debts. Each partner is personally liable for the entirety of the business's debts no matter which partner binds the partnership in a business deal. If there isn't enough money in the business to pay the debts, and another partner is broke, creditors can take the personal assets of the partners able to pay, not just each partner’s share.

Corporations and Limited Liability Companies

If a business is organized as a corporation, a shareholder’s personal assets is usually protected from business creditors. However, sloppy record keeping puts personal assets at stake for business debts when assets belonging to the business intertwine with personal finances. For example, making deliveries or sales calls with a personal car, paying personal bills from business bank accounts, or making business decisions not documented in minutes. Courts may disregard a corporate entity and pierce the corporate veil by holding individuals liable for corporate obligations where: (1) the shareholders are treating the corporation as their alter egos, ignoring corporate formalities, or (2) the corporation is inadequately capitalized. Undercapitalization is determined by looking at whether the corporation has adequate funds to cover potential liabilities.

If a business is organized as a limited liability company (LLC), an owner’s personal assets are usually protected from business creditors. However, small business owners may give up their right to limited personal liability when they give personal guarantees and/or personal security to landlords or creditors for loans, leases, or credit to a business.

Personal Guarantee or Personal Property Pledge

Without a personal guarantee, a creditor can only go after the business for business debts. A lender or supplier may not loan or transact with a business if an owner does not sign a personal guarantee. In a personal guarantee, a business owner promises to hand over personal assets if the business can't pay its debt and its assets do not cover the debt.

The owner may also secure a business debt by pledging personal property, such as a house, boat, or vehicle, which the creditor looks to first to satisfy a debt before going to other assets. However, before taking an owner's personal property, a creditor has to sue the business and prove the business didn't or can't pay the debt. Then, the creditor gets permission from the judge to take the owner's personal assets to cover the debt.

Bankruptcy Options

Do Not Hide Assets

When a business owner fears losing everything, s/he may hide personal assets by giving them to family or friends. Do not do this! An entrepreneur in bankruptcy court can be convicted for fraud when these assets get discovered.

Bankruptcy does not mean failure. Many small businesses are meant to exist for a specified period of time. Sometimes closures mean success because the owner moves on to other chapters of life such as retirement or a lucrative job. No matter all material things taken away in bankruptcy, no one can take away the owner’s talents and instincts that built the small business in the first place.

Trust the bankruptcy process to protect some assets from creditors by fully disclosing financials when borrowing money or consolidating debts. In bankruptcy, as long as an owner’s heart is beating, s/he can start over. Letting go of some belongings may never be easy. There may be business decisions to regret, but an owner can only live with the consequences of choices and residues of actions. The tragedy would be to lie awake at night and wonder “what if”, rather than be the tragic hero who makes the effort. A small business owner who files bankruptcy still has life to look forward to.

Negotiate with Creditors

Many creditors think twice before going after a business owner too hard if they think an entrepreneur will file for bankruptcy. Most creditors work out a payment plan, or settle for partial repayment. For example, a business owner may convince a landlord to lower the rent. Bankruptcy is a long process that ends with no guarantees for the creditors of getting paid anything.

Automatic Stay

Bankruptcy may not guarantee a small business owner gets to keep personal assets, but it can buy time for the owner to work things out with creditors or save cash that can be used to pay taxes or guaranteed debts. When a small business owner files bankruptcy, an automatic stay immediately stops creditors from foreclosing on a house or personal property.

Chapter 7 or Chapter 13

A sole proprietor can file either Chapter 13 or Chapter 7 bankruptcy. Either type of bankruptcy can be used for personal debts or business debts. Proprietorships can't file bankruptcy alone. The proprietor must file bankruptcy, since the assets and the liabilities of the business are just one form of assets of the proprietor.

For a corporate shareholder, LLC owner, or partnership general partner who signs a personal guarantee or pledges collateral for business debts, putting the business through bankruptcy does not protect personal property. Filing personal bankruptcy and bankruptcy for the business separately protects personal assets because only personal bankruptcy protects personal assets.

In a Chapter 7 bankruptcy, assets, except for property that is exempt under state or federal law, go into a bankruptcy estate to be liquidated, and the proceeds distributed to creditors. At the end of the process, all debts eligible for discharge will be wiped out. In a Chapter 7, owners of failed businesses exempt future earnings from the obligation to repay debt. They can start new businesses or take jobs working for others without having their future earnings burdened to repay their pre-bankruptcy debt.

Chapter 7 may be the best choice when the business has no future, no substantial assets or qualities that cannot be reproduced after bankruptcy, or the debts are so overwhelming that restructuring them is not feasible. Dischargeable debts get discharged to give the small business owner a chance to start over. In a Chapter 7, a trustee gets appointed to manage the liquidation process so this frees up the small business owner’s time to look for employment or do other things.

If the business entity is a corporation, it will not be able to use Chapter 7 because corporations don't get discharges. In a Chapter 13 bankruptcy, the small business owner proposes a court monitored repayment plan where s/he repays part or all of the debt over three to five years.

Exemptions

The bankruptcy process determines what assets to sell and how they are valued. Business owners like other bankrupt debtors surrender current assets that are above an exemption level set by the state in which they live. Examples of current assets are receivables of the business or any other property with potential resale value (i.e. customer lists, pending contracts). The non-exempt assets are used to repay debt. States with higher bankruptcy exemptions are more attractive to entrepreneurs so a business with a headquarters in one state, and incorporation in another state, may choose the state that has the higher exemption in deciding where to file bankruptcy.

The most important exemption to the business owner may be the exemption for equity in an owner-occupied home. This is the homestead exemption. Some states have unlimited homestead exemptions: Arkansas, Florida, Iowa, Kansas, Minnesota, Oklahoma, and Texas. Unlimited exemptions let individuals who file bankruptcy shelter millions of dollars of assets from creditors, as long as the assets are converted into equity in an owner-occupied home before the bankruptcy filing occurs. Shelter means the assets are out of reach of creditors for paying off debts. Some states offer no homestead exemptions: Maryland and Delaware. Besides the homestead exemption, most states exempt clothing, furniture, utensils, and retirement accounts.

Types of Debt

Consider the small business's most significant debt in deciding which type of bankruptcy to file. Is it payroll taxes? A loan? Past due rent? Unsecured creditors, like credit cards?

Payroll Tax Debt

The Internal Revenue Service (IRS) holds all business owners personally liable for unpaid payroll taxes, regardless of business structure. Payroll taxes include withheld state and Federal income taxes, Medicare and Social Security taxes, and unemployment insurance taxes. Bankruptcy is not much help when the majority of business debt is taxes. Filing bankruptcy does not result in any discharge of payroll taxes.

Not paying payroll taxes could result in penalties. To take care of payroll taxes, engage an experienced bankruptcy attorney, not an accountant, to negotiate a payment plan with the IRS or to offer less than what’s owed. If a business owner does nothing, the IRS may take personal assets to satisfy the debt.

IRS Publication 908 - Bankruptcy Tax Guide discusses the tax consequences of bankruptcy. Debtors continue to file appropriate tax forms and deposit payroll taxes withheld for employees.

Loan Debt

If the source of business debt is a loan, and a small business owner takes out the debt in his/her own name and not on behalf of the business entity, signs a personal guarantee, or pledges personal property as collateral for the loan, Chapter 7 allows the lender to foreclose on personal property to pay the loan, unless the entrepreneur owes the lender more than what the collateral is worth; after taking the collateral to pay part of the loan, the lender has to get in line with other unsecured creditors for remaining balance, and risk the bankruptcy court discharging the debt.

A small business owner should consider not keeping a personal account with the same bank that lends money to the business. When a business owes money to a bank and the owner has an account at the same bank, the bank may raid the owner’s bank account to pay a business bill.

In a Chapter 13 bankruptcy, the small business owner can continue loan payments to the lender to prevent the lender from foreclosing on the debt. If those payments are too much to make, the case may be converted to a Chapter 7.

Past Due Rent

If a business owes a landlord back rent, the small business owner is personally liable when it is a sole proprietorship or when a partner, corporate shareholder, or LLC owner personally guarantees the rent payments. Filing bankruptcy may prevent eviction and the landlord from taking personal property, especially in a Chapter 13 when there is a payment plan.

Unsecured Debt

If a business owes suppliers, the sole proprietor or partner may be personally liable. Under the Uniform Commercial Code, suppliers usually have the right to take the goods back. Filing Chapter 13 could organize a payment plan. Chapter 7 may wipe out the debt.

For a corporation or LLC, unsecured debt is rarely personally guaranteed. Suppliers may be out of luck when a corporation or LLC has no assets because an owner is protected from personal liability. A shareholder or LLC owner with only unsecured, unguaranteed business debt may not need to file a personal bankruptcy.

However, if an owner uses personal credit cards or home equity loans to obtain funds for a business, the owner is personally liable for those debts.

After Bankruptcy

Retaining and attracting customers is essential for a business to stay afloat. If customers think a small business may shut its doors, they're going to go elsewhere. Who would want to work with a business that may not honor its gift cards, return policy, or warranty? A small business owner should keep customers apprised of the business’ financial health.

Just like customers, suppliers want to know that a business is reliable —that they're going to get paid. No one wants to work for free. Agreeing to pay someone to do work is a test of honesty. Why would a vendor work for free when an enterprise is for profit? Negotiate payment terms or pay in advance or on delivery so vendors know they will be paid what’s owed. While in bankruptcy, a business can also file a motion with the bankruptcy court to grant the vendor "critical vendor status" to give an essential vendor a higher priority on the repayment line.

After bankruptcy, the business needs to rebuild credit. Attain a secured business credit card. An owner may need to pay an initial deposit to secure the card. These cards may have high interest rates and card fees, but the card issuer extends a line of credit equal to the amount of the deposit to allow the card holder to earn a credit line after consistent timely payments for a certain period. In addition to getting a secured credit line, establish lines of credit with vendors. Then, be sure to pay all obligations on time.

Advice from a Small Business Attorney

Get advice from a Rinne Legal small business attorney with bankruptcy experience before filing bankruptcy. Bankruptcy stays on a credit report for up to ten years, and can make it hard for a small business owner to open another business.

An experienced bankruptcy can advise on the bankruptcy process and pre-bankruptcy planning.