Chapter 1

Evaluate Your Debts and Your Business

Assess Your Personal Liability for Business Debts..................................... 6

Sole Proprietorships and Partnerships.................................................... 7

Corporation or LLC.................................................................................. 7

Assess Your Spouse’s Liability for Business Debts................................... 10

Community Property States.................................................................. 10

Common Law States............................................................................. 11

Assess Whether Your Business Is Viable.................................................. 12

Is Your Business Economically Viable?................................................ 12

Do You Want to Continue Owning the Business?................................. 13

This book is for business owners who are considering filing for personal Chapter 7 bankruptcy—not for those who want to file a bankruptcy case for the business itself. Why this distinction? Because there is a big difference between debts that only your business owes and debts that you are personally responsible to repay. Chapter 7 personal bankruptcy wipes out your personal liability for debts; it doesn’t wipe out debts that a corporation or limited liability company (LLC) owes separately.

If your business is a separate legal entity that offers limited liability—such as a corporation or LLC—and you have not personally guaranteed or otherwise taken legal responsibility for its debts, the business is responsible for paying its own debts. If the assets of the corporation or LLC aren’t sufficient to satisfy those debts, business creditors are out of luck. They usually cannot come after your personal assets, such as your personal bank account and your equity in your house, other real estate, or vehicles, for repayment (unless a court rules that you have failed to treat your business as a separate entity and, therefore, are not entitled to the limited liability protection you’d otherwise enjoy; see “Fraud, Misrepresentation, or Sloppy Record Keeping,” below, for more information on this exception).

But if your business is a sole proprietorship or general partnership, your business is not a separate entity, and you are legally responsible for paying its debts. If the business can’t pay its own way, your personal assets are at risk.

To decide whether filing for Chapter 7 personal bankruptcy makes sense, you must first understand which debts (if any) you are personally liable for. This chapter will help you evaluate your (and your spouse’s) liability for your business’s debts. It will also help you assess the condition of your company and decide whether you want to close the business down and or try to stay in business. Answering these preliminary questions will give you the information you need to weigh your options for dealing with your business debt.

Assess Your Personal Liability for Business Debts

Many small business owners see their businesses as an extension of themselves. It can be tough (not to mention stressful and costly) to start a business, and the daring entrepreneurs who make a go of it often pour their energy, time, and money into their ventures. Perhaps you started your business with your personal savings or money from an inheritance, use your spouse’s paycheck (or your paycheck from a day job) to fund its operations, use your own car for deliveries or sales calls, or have pledged your own property and used your own credit to get the money you need to keep the business running. Practices like these can make it hard to figure out where your business’s finances end and yours begin.

Because their business and personal finances are so often intertwined, small business owners often face collection efforts against their business assets and their personal property. In looking at your options, one of your first tasks will be to figure out which business debts you are personally liable for and which are owed only by your business.

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 in detail in this book).

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.

CAUTION

Whether your business is organized as a corporation, LLC, partnership, or sole proprietorship, you are legally responsible to pay taxes your business withheld from employee paychecks. The IRS isn’t interested in any of the details: If you withheld those taxes, you are personally liable if you don’t pay that money to the government.

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 (discussed below), 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.

Below are some common ways an owner of a corporation or an LLC might become personally liable for the business’s debts. If you are personally liable for some or all of your business debts, you will have to file a personal bankruptcy, rather than a business bankruptcy, to rid yourself of these debts.

Signing a Personal Guarantee

Because most suppliers, banks, and landlords know that corporate shareholders and LLC members aren’t personally liable for business debts, they often won’t extend credit or lend money to a small corporation or LLC without an owner’s personal guarantee: a legally binding agreement that the owner will repay the debt if the business can’t. And many small business owners are willing to sign a personal guarantee, even though they incorporated or formed an LLC precisely to limit their liability for obligations relating to the business, because they can’t get the money otherwise.

Check to see whether you signed a personal guarantee on any of your business contracts, such as a loan for a business vehicle or business equipment, trade terms with a supplier, a bank line of credit, or a commercial lease. If so, the creditor can go after your personal assets for repayment.

Offering Your Property as Collateral

Banks often require the owners of small corporations or LLCs to put up their home or other real estate as security for a loan. If you secured a business loan or debt by pledging personal property, such as your house, boat, or car, you are personally liable for the debt. If your business defaults on the loan, the lender or creditor can sue you to foreclose on the property (collateral) and use the proceeds to repay the debt. Filing for Chapter 7 personal bankruptcy will wipe out your personal liability for this type of loan, but the lender’s lien on the collateral will survive. This means you’ll eventually have to pay off the debt if you sell the property; what ­happens to liens in bankruptcy is covered in Ch. 8.

Signing a Contract in Your Own Name

You may also have given up your limited liability if you were careless about signing purchase agreements and service contracts for your business. Sometimes these agreements display the personal name of the business owner without the name of the corporation or LLC. If you signed an agreement in your personal name and not on behalf of the corporation or LLC, you’re personally liable for the underlying debt, even if it was a simple mistake. If you’re not sure whether you signed an agreement or loan personally, check the language of the agreement and the signature block to see whether you signed it in your name or in your capacity as an owner or officer.

Example: Talia signs a loan contract as Talia Smith, CEO of Cook’s Nook, Inc., which means only her incorporated business is liable to repay the loan. But Talia then signs her commercial lease as just Talia Smith (without any mention of Cook’s Nook, Inc.). Talia will be personally liable to the landlord if her business can’t pay the rent.

Using Credit Cards or Personal Loans to Fund the Business

If you used credit cards or home equity loans to obtain funds for your business, you are personally liable for those debts. (Under the terms of most credit card applications, even those used in the name of a corporation or LLC, you agree to be personally liable for making all payments.)

Example: Amy and Adam open a coffee roastery and café offering weekly poetry readings. To get their business started, they file LLC formation papers with the state and spend $35,000 on a brand new roaster that can crank out a thousand pounds of coffee per day. Unable to get a small business loan, they charge the coffee roaster on their personal credit cards, figuring they will pay it off quickly with income from the business. They also sign a two-year lease on a corner building in an artsy neighborhood, for which the landlord requires their personal signatures. They arrange for weekly deliveries of beans from a nearby wholesaler, with invoices in the name of Cozy Roast LLC.

Unfortunately, when they open their doors, crowds fail to appear, and Amy and Adam realize that their original sales forecast was too optimistic by half. Five months later, still operating in the red, they decide to close down. They are personally liable for their $35,000 credit card debt for the coffee roaster as well as the remaining months on their two-year lease (unless the landlord can find a replacement tenant). Because Amy and Adam didn’t personally sign or guarantee a contract for the coffee bean deliveries, only the business is liable to pay the bean invoices (assuming Amy and Adam have properly followed LLC formalities). Amy and Adam consider filing for Chapter 7 personal bankruptcy to get rid of their credit card debt and obligation to the landlord.

Tortious Conduct

Generally, owners of corporations and LLCs are not personally liable for mistakes in management, but they can be held personally liable for injuring others. An owner who commits a tort (the legal term for an act that harms another person and causes monetary loss) can be held personally liable.

Example: Brian, the owner of an LLC, speeds through a residential neighborhood and runs a red light, causing an accident. Damages to the other vehicles, which were totaled, exceed his $50,000 liability insurance policy by $40,000 (he hit a Lexus and a Mercedes). Even though Brian was driving on work-related business, the LLC’s limited liability does not protect Brian from being sued personally for the automobile damages.

Fraud, Misrepresentation, or Sloppy Record Keeping

If you misrepresented or lied about any facts when you applied for a loan or credit on behalf of your corporation or LLC, you could be held personally liable for the debt. Likewise, if you failed to maintain a formal legal separation between your business and your personal financial affairs, creditors could try to hold you personally responsible for the business’s debts under a theory known as “piercing the corporate veil.” This happens when a court finds that your corporation or LLC is really just a sham and you are personally operating the business as if the corporation or LLC didn’t exist. In this situation, a court may decide that you aren’t entitled to the limited liability that your business structure would ordinarily provide.

One way creditors try to pierce the corporate veil is by showing that you didn’t observe the legal formalities imposed on corporations and LLCs. For instance, you may have made important corporate or LLC decisions without recording them in minutes of a meeting. Or, you may have paid business bills from a personal checking or credit card account or paid personal bills from your business bank account. Even corporations or LLCs owned by a single individual or a married couple have to obey the rules and formalities imposed on these business structures; otherwise, they risk losing their limited liability protection.

Tip

List all business debts in your personal bankruptcy filing, just in case your “veil” is pieced. Even if you don’t think you are personally liable for a corporate or LLC debt, you should list all business debts when you file for Chapter 7 personal bankruptcy. Business creditors might try to pierce your corporate veil and sue you personally for those debts. But if you list your business creditors in your personal Chapter 7 paperwork, any potential personal liability for the business debt will be extinguished in the Chapter 7 personal bankruptcy—even though the business debt will remain on the corporation or LLC’s books. If you’re concerned about personal liability for your corporation’s or LLC’s debts, you should also talk to a lawyer to make sure you’re doing all you can to protect yourself. At a minimum, when you list these business debts in your bankruptcy forms, check the “disputed” column (see Ch. 9), so you won’t be admitting liability down the road if any of these debts survive your bankruptcy.

Assess Your Spouse’s Liability for Business Debts

After reading the section above, you should be able to figure out which debts you are personally liable for and which you are not. But that isn’t the end of the story: Your spouse’s personal liability for your business debts could also affect your decision about filing for Chapter 7 personal bankruptcy. For instance, if your spouse is liable for your business debts and has assets or income to lose, it might make sense for both of you to file for personal bankruptcy.

Whether your spouse is liable for your business debts turns mostly on where you live. So, it’s time for a little geography lesson.

CAUTION

If you live in a state that allows same-sex marriage, same-sex spouses are subject to the same rules about joint and separate debt that apply to other married couples. Some states that don’t recognize same-sex marriage allow same-sex couples to register their union in some form (for example, as domestic partners) and thereby gain some of the benefits and obligations of marriage—which may include joint obligations for debt. If you are concerned about your same-sex partner’s liability for business debts, consult with an attorney. As explained in Ch. 5, however, same-sex couples may not file jointly for bankruptcy, even if they are married.

Community Property States

In the community property states (listed below), all income either spouse earns during marriage, as well as all property bought with that income, is community property, owned equally by husband and wife. For the most part, any debt incurred by one spouse during marriage is owed by both of them, too; it’s a community debt, and the spouse’s creditor can go after community property as a source of repayment (although they rarely do when the debt is in one spouse’s name). So, if you live in a community property state, you may want to file for bankruptcy to wipe out your business debts and protect your community income and property; even if you currently have little or no income, your spouse may have a good job.

In Ch. 9, we discuss the pros and cons of filing jointly or separately in a community property state.

Example: Shelley runs a sporting goods store in Tacoma, Washington, as a sole proprietor; her husband is a local bank executive. Even though Shelley’s husband isn’t involved in the business, he and Shelley own the business jointly, because Shelley started the business with income earned after they married. Over the last few years, Shelley’s store has been suffering from poor sales. She finally decides to close her doors, owing $40,000 to suppliers, $25,000 to her landlord, and $15,000 in other debt.

Because Shelley and her husband live in a community property state, her business creditors can sue both Shelley and her husband personally to collect the money owed. Shelley no longer has any income to take, but her husband’s earnings are significant. To prevent her creditors from garnishing her husband’s income or suing the couple to take their personal assets, Shelley files for personal bankruptcy, which discharges her business debts, Shelley’s personal debts, and any personal debts owed jointly by Shelley and her husband. (If Shelley’s husband has separate personal debts, such as a lawsuit judgment against him that predates their marriage, those debts will not be affected by Shelley’s bankruptcy filing.)

Common Law States

The law works differently in what we refer to as “common law” marital property states (that is, the states that don’t appear on the list of community property states, above). In these states, debts incurred by one spouse—even during the marriage—are generally that spouse’s debts alone, and only that spouse’s income and property are liable for the debt. Debts are jointly owed by both spouses only if they were jointly undertaken. A debt might be jointly owed if any of the following are true, for example:

Both spouses signed a contract requiring them to make payments.

Both spouses’ names appear on an account or title to property.

A creditor was given both spouses’ credit information as part of an application for a loan.

The debt benefited the marriage. In other words, it was for food, clothing, child care, necessary household items, or similar items of direct benefit to the family.

All other debts, such as a business debt from one spouse’s business, a loan for a car whose title is in only one spouse’s name, or credit card debt in one spouse’s name only, are considered that spouse’s separate debts.

One spouse’s creditors cannot legally reach the other spouse’s separate money, property, or wages to repay a separate debt. However, if income earned by one spouse is put into a joint bank account or investment account, that income becomes a joint asset, which a creditor can go after. Fortunately, in most common law states, a creditor can take only half of the money in a joint account to pay a spouse’s separate business debts. 

In many common law states, spouses can jointly own property in a form known as tenancy by the entirety. The rules for when creditors can proceed against property held in tenancy by the entirety are complex (see Ch. 5 for more informa­tion). However, the basic idea is that property held in tenancy by the entirety is protected from the separate creditors of a spouse.

See an Expert

If you’re concerned about your spouse’s liability, see a lawyer. If you have run up a pile of business debts and your spouse owns lots of separate property (whether or not it’s kept in a joint account), we recommend that you see a lawyer to find out how to best protect your spouse’s assets.

Example: Robert Horton, the sole owner of Horton Rental, rents construction equip­ment and party furniture and supplies in Albany, New York. His wife Amanda is an independent jewelry appraiser who makes a good living. Robert hasn’t been able to pay Horton Rental’s bills for several months, and a creditor is threatening to sue the couple.

Because the Hortons live in a common law property state, the creditor can’t sue Amanda and garnish her income. And, because the Hortons hold title to their house in tenancy by the entirety, New York law prevents creditors from forcing its sale, as long as Amanda is alive. If Amanda and Robert were to sell the house, however, the creditor would be entitled to payment from Robert’s half of the proceeds.

If you and your spouse have not kept your income and property separate, and your spouse brings significant income and/or assets to the table, filing together for bankruptcy can be advantageous. We discuss the pros and cons of filing separately in Ch. 9.

Assess Whether Your Business Is Viable

Now you know how much of your business debt you (and perhaps your spouse) are personally liable to repay. If you are personally liable for a significant amount of debt, Chapter 7 personal bankruptcy might be a good choice for you. Before making the decision, however, you also need to take a hard look at your business. Undoubtedly, you’re considering bankruptcy because the business hasn’t done well. But could it do better in the future, or is it time to close the doors for good? And if you think prospects could improve for the business, do you want to continue at the helm?

Is Your Business Economically Viable?

Let’s focus first on whether your business can be saved. The answer affects whether you decide to keep your business open and which strategy for handling your business debt makes the most sense.

You wouldn’t be reading this book if your business was going gangbusters. So we’ll start with the assumption that your business is performing poorly and deep in debt. But does this mean that your business could never turn a profit?

If your past-due debts to your suppliers, landlord, utility providers, and other creditors were erased, either through negotiating settlements or through a bankruptcy process that allowed your business to stay open, could your business begin to break even? Could it stay in the black for the foreseeable future and produce enough income to cover your living expenses? To answer these questions, use your recent expense and income figures to come up with a profit-and-loss forecast and cash-flow analysis—using real numbers, not guesses or rosy estimates.

Resource

Help with financial spreadsheets and business viability. For help assessing whether your business can return to profitability, read Save Your Small Business: 10 Crucial Strategies to Rescue Your Business or Close Down and Move On, by Ralph Warner, J.D, and Bethany Laurence, J.D. (Nolo). This book explains in detail how to make a profit (including, for those who need it, how to complete a profit-and-loss forecast and cash-flow analysis) and offers an entire toolkit of marketing ideas that will help you turn your business around.

If you’ve looked at the financials and you think your business can turn a profit in the long run, it may make sense to stay open while trying to reduce your debt, either through negotiating settlements with your creditors (called a debt workout) or filing a type of bankruptcy that will allow you to keep running your business. If you run a service business with few assets, you might even be able to keep your doors open while you file for Chapter 7 personal bankruptcy. Ordinarily, however, the owner of a business with significant assets or inventory would have to file for Chapter 13 bankruptcy to stay open. (As explained in Ch. 3, Chapter 13 bankruptcy requires you to come up with a plan to pay off some or all of your debts over three to five years.)

Before you spend a lot of time and money trying to save your business by arranging a debt workout or filing for bankruptcy, make sure your business plan will allow your business to become profitable in the next 12 to 18 months, not just to break even. It doesn’t make sense to invest the time, trouble, and sleepless nights required to turn your business around unless you see a pot of gold at the end of the rainbow. If you can’t become profitable within that time, it may make more sense to cut your losses now by closing the business, filing for Chapter 7 personal bankruptcy to wipe out your debt, and deciding whether to start over with a new business.

While it can be agonizing to decide to close your business down, the sooner you make this decision, the better off you will be if you decide to file for Chapter 7 personal bankruptcy. Bankruptcy law prohibits certain transactions close to the time of a bankruptcy filing, including actions you might want to take to preserve your assets or pay off favored creditors. The more time you have, the more flexibility you will have in arranging your affairs before filing for bankruptcy.

Do You Want to Continue Owning the Business?

If you think your business has a financial future, you’ll need to decide whether you want to be part of it. This decision might depend on lots of factors beyond the prospects of your business, including your health, age, family situation, and career alternatives.

If you’ve come to realize that running a business (or running this particular business) isn’t your cup of tea, this may be your opportunity to move on to more fulfilling opportunities. In this situation, you’ll want to look at how much money you can squeeze out of the business, in or out of bankruptcy, before you close the doors. On the other hand, if you love running your business, your financial assessment may be focused more on how to keep it running at all costs.

Once you decide either that you want to keep running the business or that you want to move on to other things, you’ll have an easier time assessing the financial condition of your business. This is especially true if you are willing to let the business go, because you will no longer be tempted to exaggerate the chances of a turnaround.

At this point, you should have a good sense of whether you want to continue operating your business—and whether that’s a good idea financially. You also know the extent of your (and your spouse’s) personal liability for the business’s debts. Armed with this information, it’s time to consider whether Chapter 7 personal bankruptcy is the best strategy for dealing with your business debt.