Businesses are not liable for the personal debts of the business owner. Likewise, neither is the business owner automatically liable for the debts of the business. There are two ways in which personal liability for business debts can arise: by personal guarantee or if the corporate veil is pierced.
Many a business bankruptcy has also lead to personal bankruptcy. But that’s usually only necessary if the business owner has personal liability for business debts.
Do you have contractual personal liability for business debts?
Typically, creditors extend credit to small business owners based on the business owner’s personal credit. If you have given your personal guarantee on a business debt, then the creditor will not simply walk away if the business cannot pay. Your personal liability on that debt was a bargained-for term of the original contract. Your personal guarantee gives rise to concurrent liability for the business and for yourself.
Whether you have personal liability by explicitly contractual terms depends upon the originating loan documents. If the signature block states only the business name and a “By:” line for an officer of the company, then the business may be solely liable. If, however, the signature block or another term in the contract requires a personal guarantee (or a separate signature), then the loan likely gives rise to personal liability.
A good example of a local creditor that requires personal guarantees on business debts is On Deck Capital, a small business lender whose choice of venue is Arlington General District Court. On Deck requires a personal guarantee on every loan it makes, and subsequently names individual business owners as defendants in every lawsuit it files.
Can the creditor pierce the corporate veil?
Business owners may choose a corporate structure like a limited liability corporation (LLC) to limit the business owner’s personal liability for business debts. The reason for doing so is to protect the business owner’s personal assets from attachment by business creditors. But if a creditor is able to “pierce the corporate veil,” then the business owner’s assets may be attacked.
Yet piercing the corporate veil is the exception to the rule. Stated another way, courts will allow a plaintiff to pierce the corporate veil only to prevent fraud, illegality, or injustice. A plaintiff must demonstrate that the owner of the business abused the privilege of doing business in the corporate form.
Factors that courts consider in determining whether to pierce the corporate veil include:
- Failure to adhere to corporate formalities
- Inadequate capitalization at corporate formation
- Commingling of personal and business assets
- Use of corporate funds for personal use
- Overlap in ownership, officers, directors, and personnel
- Common elements between multiple corporate entities
No one of these factors is more important than any other, and courts look at the totality of the evidence.
Mere insolvency of the business is not enough to allow a creditor to pierce the corporate veil. Courts do not allow the veil to be pierced merely because the corporation does not have sufficient funds to pay its debts.
You must litigate against a creditor seeking to enforce its debt
Do not simply ignore a creditor because your business is on the verge of insolvency. If a creditor goes through the added expense of suing the business, that creditor is serious about collecting on its debt. You must mount a defense if you believe that the creditor will seek to attack your personal assets, as well.
This is especially true if you personally guaranteed a business debt. A creditor will most likely name both you and the business in the same lawsuit. Do not allow a default judgment to be entered simply because the business is going under. The creditor will use that judgment against you, personally.
Bankruptcy discharges personal liability for business debts
Business bankruptcy does not eliminate personal liability for business debts. Only a personal bankruptcy will accomplish that. Trying to keep open a failing business is exhausting. Facing personal financial failure at the same time can be debilitating. Personal bankruptcy allows business owners to discharge business debts.
Bankruptcy actually promotes entrepreneurship. And bankruptcy debtors with mostly business debts do not need to qualify for Chapter 7 under the means test. The liquidation bankruptcy process for business owners is simplified for a reason. Bankruptcy provides an escape route for people who want to try again.