Small business is the backbone of our economy. There are literally millions of small businesses in the United States and at any given time, a large percentage of them are failing.
Many Arizonans with small businesses have contacted me when faced with serious business-related debt to ask whether a creditor(s) can sue them personally for debts incurred to create and maintain the business.
A small business owner’s personal liability usually is determined by whether the debt has been personally guaranteed. I.E. did the business owner borrow the money in his or her own name or did they personally promise to pay if the business couldn’t. If so, a lawsuit and collection can follow.
The related question is whether the “structure” of the business provides any protection for the small business owner?
Sole Proprietorship – The most common business structure
If you are what is commonly known as a “sole proprietor“, the business is you and you are the business. You have probably personally signed off on every loan, credit card debt, lease etc. If so, you can be sued personally and your personal assets are up for grabs.
General Partnership – provides no protection
Partners in this type of structure are personally liable for the debts of the partnership, all of it. Worse yet, ANY one partner can tie the entire partnership to a loan. If you are a partner in a general partnership in Arizona and the whole project goes “south”, you may be in trouble and not even know how much.
Corporate entities and Limited Liability Companies
These types of entities protect your personal assets and income from the business creditors, not personal creditors as described above. By statute, the shareholder or member of the LLC has limited personal liability.
I find that most small business owners who have organized the business as an LLC or Corporate entity, have also provided the various creditors, landlords etc. a personal guarantee in order to borrow the money or obtain the lease. If you have done this, then the business creditor can go after those assets and your income after suing you and obtaining a judgment.
So, if you are a sole proprietor, a general partner or have otherwise personally guaranteed debt or lost the protection of your corporate/LLC umbrella, what do can you do to deal with the debt?
1. Debt Negotiation
Most creditors will consider reducing the amount they are paid and forgiving the rest. Even business creditors. I find that negotiating serious business debt doesn’t work well unless the “debtor” has some present asset or cash with which to negotiate. There are other negatives as well. You can read about the pros and cons of negotiating debt in more detail by reading this entry, debt negotiation – pros and cons.
Any individual that owes a debt as a result of a personal guarantee, general partnership debt, etc can file bankruptcy (Chapter 7, 13 and even 11 if necessary) in order to protect their exempt assets and future income.
The business as a separate entity may or may not need to file a bankruptcy. Corporation, LLCs and partnerships are legal entities and can only file a chapter 7 to liquidate and close shop or chapter 11 to “reorganize”. No chapter 13 bankruptcy is available, and no “discharge” of the debt is available to the corporate entity.
Reorganizing under chapter 11 will only make sense if the business may become viable as a result. Chapter 7 liquidation may only be necessary for the corporate entity if a creditor is about to take a business asset that could be used to pay a personal priority debt, bankruptcy trustee involvement makes sense to help in winding down the business within the protective arms of the bankruptcy code, or if the bankruptcy filing would cause creditors to “close the file” and leave officers and shareholders alone.
If personal bankruptcy is the option, then typically the choice will be between a chapter 7 and a chapter 13.
In a chapter 7 bankruptcy, the non-exempt assets or assets not protected by state law from collection by creditors are taken by the bankruptcy trustee, liquidated and paid out to creditors in varying priorities. Most debt is then wiped away.
In a chapter 13 bankruptcy, a payment plan is proposed. That plan calls for you to pay part or all, (usually a small part) to your creditors in monthly installments for a three to five year period. Typically, most non-exempt assets are protected for liquidation as a result. Most other debt is then wiped away.
If the majority of your debt as a result of the failed business is “priority” debt, then the benefit of bankruptcy may be significantly reduced.