Can a creditor raid your personal bank account, garnish your wages, take your car, or foreclose on your house to recover debts incurred by your business? It depends on the nature of the debt, how your business is structured, and the state where you operate.
To determine whether your personal assets can be taken to pay your business debts, the first thing you'll need to look at is your company's structure. The different types of business entities – sole proprietorships, limited liability companies (LLCs), partnerships,and corporations – define the legal relationship between the business owner and the business. The more your business entity type separates you, as the owner, from the business, the less likely it is that your personal assets can be used to pay for your company's debts.
With a sole proprietorship, you and your business are legally the same, which is another way of saying that you personally owe every penny that your business can't pay. With a few exceptions--most states allow you to keep some portion of your assets in bankruptcy proceedings--a creditor can use your personal assets to pay debts your business owes.
The same principle applies to general partnerships. The business debts belong to each partner personally with this added twist: Each partner is personally liable for 100 percent of the business's debts, not just the share that represents each partner's ownership percentage. If your partnership can't pay its debts, and your partners refuse or claim poverty (but you have the wherewithal to cover the debt), a creditor can take your assets to pay off all the business debts. (If you pay the entire debt, you can always sue your partners for reimbursement—though this will probably spell the end of your working relationship.)
In a limited partnership (a partnership that consists of at least one general partner and one limited partner), only the general partner has responsibility for the business's debts, and creditors can use this partner's personal assets to pay them. The limited partners don't have personal liability.
If your business is organized as a corporation or LLC, you and your business are separate legal entities. You can't be held personally liable if your business can't pay its debts, as long as the expenditure was business-related. (If your business buys a yacht that has nothing to do with the business and that it can't pay for, don't expect that your personal assets won't be at risk if the business fails to make payments.) Other "but onlys" apply (see "Other Situations When You Risk Your Limited Liability," below), and even when the expenditure was legit, your personal assets might still be at risk depending on how the debt was secured and the state where you operate.
Secured debt is a loan, line of credit, or purchase you finance by agreeing that your property or other personal assets can be used as payment if you default. When a business takes out a loan, the lender will typically require a personal guarantee from the owners if the business is not robust and financially secure, and in this case, the personal guarantee secures the loan.
A loan, line of credit, or purchase that's made with no such condition is unsecured debt. Credit cards are technically unsecured because you don't have to pledge your property to get one. But as you'll see below, your personal assets can be used to repay your business's credit card debt.
If you've ever financed a car purchase at the dealership, you've taken on a secured loan. The loan agreement you signed gives you the ability to pay for the car in installments, and it gives the dealer the right to repossess the car if you fail to make the payments. In this case, the car is what's called collateral, property that you've pledged in exchange for the loan. If you fail to make your payments, you can (and likely will) forfeit your car.
Collateral. Debt can be secured by a pledge to give up the property you are purchasing if you don't make payments as in the dealer example above, or it can be secured with property you already own. SBA lenders, for example, might require you to put up your house or other property as collateral to get a business loan. If your business defaults on the loan, the bank can sue you to foreclose on the property (some states allow lenders to skip the lawsuit) and use the proceeds of the sale to pay off the loan.
A Personal Guarantee. When you sign a lease or other type of purchase agreement that requires monthly payments, you usually will have to agree to personally make those payments if your business can't. Landlords typically require the owner of a new business to personally guarantee the lease. For example, if you sign a three-year lease for offices for your business, and it includes a personal guarantee clause, you can be held personally liable for paying the rent for the duration of the lease term if your business closes. Personal guarantees are less likely when the business is established, has a good credit history, and has solid assets.
Most credit card companies use a personal guarantee clause in their applications. When you sign up for a credit card for your business, both you, as the business owner, and the business, are jointly responsible for paying the credit card charges. If the business can't pay, you'll have to, whether you have a Visa or an Amex Platinum Card, and regardless of whether you used the card to buy supplies for your business or fund it.
Corporate credit card applications typically don't require personal guarantees, and you, as the owner, would not be personally liable for that credit card debt. But many businesses are not eligible for corporate credit cards. They are typically issued only to well-established businesses with significant revenues and a long credit history.
As noted above, even owners of an LLC or corporation can't rest easy if they use their business to buy items that have nothing to do with the business, in the hopes of saving their personal assets if they don't make the payments. Creditors can reach personal assets, known as "piercing the corporate veil" (more examples below). Here are some additional exceptions to limited liability faced by all business types.
Employers are personally liable if the business doesn't pay employee withholding taxes. If your business has employees, you are required to withhold taxes from your employee's paychecks and send those taxes to the state and IRS. If your business fails to follow the required procedures for paying withholding taxes, you, as the owner, are personally liable for the payment regardless of the type of business entity you have.
State rules might override limited liability. Each state sets its own rules for corporations and LLCs. Some states are considered creditor-friendly and others are considered debtor-friendly because of the way their laws are written and interpreted by the courts when they are challenged. States can also amend their rules based on court rulings, and it's important to keep abreast of changes.
For example, a member of an LLC in Arizona can be held personally liable if the company fails to pay privilege tax (a type of sales tax). In New York State, the court found that the 10 largest members of a foreign LLC (an LLC that does business in multiple states) could be held personally liable for unpaid employee wages.
You signed a contract or agreement using only your own name. Of course, your business can't physically sign a contract or purchase agreement, and you, as the owner, must sign on behalf of the business. But you can jeopardize your limited liability if you enter a contract using only your name, and you fail to include your business name and your relationship to the business in the contract.
Let's say you are the owner and CEO of Glam Footwear, an LLC that operates a small chain of shoe stores. You place a large purchase order for the fall season, and you neglect to carefully review the purchase agreement. The agreement starts with, "purchase agreement between Jane Smith and Shoe Importers, Inc., when it should say, "purchase agreement between Glam Footwear LLC and Shoe Importers, Inc." You sign the agreement as Jane Smith instead of Jane Smith, CEO of Glam Footwear LLC.
Now imagine that Glam Footwear's business drops dramatically over the summer, and by the time the shoe shipment arrives, the company's cash flow is depleted and it can't pay for the fall merchandise shipment. The way you entered into and signed the purchase agreement makes you, Jane Smith, responsible for paying the invoice, even though your company structure gives you limited liability.
Your corporate veil has been pierced. Creditors can hold you personally responsible for your business's debts if your corporation or LLC doesn't follow the rules established by your state for that business entity. This theory is known as "piercing the corporate veil." Some examples are:
When a creditor is able to show that any of these types of criminal activity, fraud, misrepresentation or sloppy recordkeeping occurred, a court can decide that your business entity is really just a sham, and you don't have limited liability in these situations.
The other side of the coin is whether creditors can come after your business if you fail to pay your personal debts.
In general, the same rules apply. If you are an owner of a corporation or LLC, you are a separate entity from the business, and the business isn't responsible for your personal debts. But while creditors generally can't take your business assets to pay your personal debts, they can take funds your business owes you. (Getting money that the LLC owes its member is called a "charging order," in which the court orders the LLC to pay the creditor instead.) In a corporation, a creditor with a judgment against a shareholder could end up controlling the business, as you'll see below.
For example, a creditor with a judgment against an LLC member can come after any distributions that would have been made to the member, but not the member's share of ownership in the LLC. Most states will not order a forced sale to pay the debt.
Liability for corporate shareholders is different from that of LLCs because the shares of stock they own in the company are considered personal assets. A creditor with a judgment against a corporate shareholder can take the shares of stock the shareholder owns, and along with it, the voting rights granted by those shares. If the debt is large enough, and the shareholder owns a majority of the stock shares, the creditor can take over the company and even force it to be liquidated.