When You Can't Pay Your Business Debts: Personal Liability and Bankruptcy Options

Learn which of your business’s debts you're personally liable for, when bankruptcy might make sense, and how each bankruptcy type works.

By , Attorney

If your business is in distress and can't pay its debts, your creditors will probably threaten legal action against you personally. How much your creditors can collect will depend on:

  • how your business is organized—for example, sole proprietorship or corporation
  • whether you personally guaranteed any repayments, and
  • whether you decide to file for bankruptcy.

Personal Liability for Business Debts

Whether you have personal liability for some of your business debts will influence your decision on whether to close your business, file for bankruptcy, or both.

What Is a Personal Guarantee?

If you personally signed for a business loan—that is, you signed on behalf of yourself and not the business—then you'll be personally responsible for the loan. You've made a personal guarantee.

Your bank or lender might require a personal guarantee to assure that the loan can be repaid if your business doesn't have enough collateral or assets, or a steady revenue stream. If your business can't pay the loan, then the creditor can come after you personally.

For example, assume Samantha just opened her new boutique and applies for a loan under her LLC to help her with operating costs. Because Samantha has a new business and doesn't have many assets or much revenue to show, the bank requires Samantha herself to personally guarantee the loan. Two years later, her business has hit a snag and she can't make payments on the loan. The bank can come after Samantha directly for payment because she personally guaranteed the loan.

How Does Business Structure Affect Your Personal Liability?

Even if you haven't provided a personal guarantee, you could still be personally responsible for a business loan or debt. Your personal liability will depend on your business's structure.

Sole Proprietorship

If you're a sole proprietor, your business debt and personal debt are one and the same. Because legally you're considered a single entity, you'll be personally liable for your business's debts, and creditors can come directly after you.

Partnership

In a partnership, if your business can't pay its debts, the partners will be liable for making up the difference with their own money. State law or a partnership agreement will lay out how much each partner is responsible for.

Creditors can come after any or all partners to collect on a debt, because the partners are considered jointly liable. If one partner ends up having to pay the creditor more than they should‘ve had to according to the partnership agreement or state law, then that partner would have to recoup the difference from the other partner or partners.

For example, suppose one partner pays a creditor a $10,000 debt but the partnership agreement says the partner is only responsible for 50% of the partnership debts.The partner that paid the debt could then recover $5,000—50% of the $10,000 debt—from the other partner.

Limited Liability Company (LLC)

As the name would suggest, LLCs offer their owners and managers limited personal liability. Unless the owners or managers commit some wrongdoing or don't treat the LLC as a separate, distinct entity, the LLC alone is responsible for all business debts.

For instance, if the members of an LLC pay for business expenses with personal funds instead of business funds, then the LLC becomes less of a distinct entity and the members could be liable for the company's debts.

Corporation

Much like LLCs, corporations shield their officers, directors, and shareholders from liability. You'll only be responsible for business debts in a corporation if the corporate veil is pierced. A corporate veil is pierced either when the court decides that the officers, directors, and shareholders and the corporation act like a single entity or when there's been fraud or other misconduct. Piercing the corporate veil is common in smaller corporations because there's more involvement by individuals in the corporation's day-to-day activities.

For instance, suppose Kim, Arjun, and Leon are the sole shareholders of their corporation and also serve as the directors and officers. They regularly pay for rent and supplies with their own money and haven't made bylaws or held annual meetings. Due to their actions and inactions, a court could rule that the corporate veil has been pierced.

Is Bankruptcy a Good Option For You and Your Business?

If your business bank account is empty and you're in a lot of debt, you might be considering business or personal bankruptcy. Although it doesn't guarantee that your business will survive, it can at least give you some breathing room.

Business vs. Personal Bankruptcy

There are three primary types of bankruptcy:

Any individual can file for Chapter 7, 11, or 13 bankruptcy for personal debts. However, because Chapter 11 is usually used to reorganize a business, individuals usually file under the other two chapters.

Chapter 7 and Chapter 11 bankruptcy are available to all businesses for business debts. Businesses can't file under Chapter 13, unless they're a sole proprietor.

Keep in mind that, if you're a corporate shareholder, LLC owner, or partner in a partnership and you've signed personal guarantees or pledged collateral for business loans, putting your business through bankruptcy won't protect your personal property.

If you're a sole proprietor, you can file for any type of bankruptcy. Any of the chapter bankruptcies can be used for personal or business debts because legally you and your sole proprietorship are the same entity and therefore have the same debts. But you might find that Chapters 7 and 13 are the most advantageous.

Ultimately, whether you file for personal or business bankruptcy and which chapter you choose involve a number of considerations. You might find that your business is ineligible to file for a particular type of bankruptcy or that it would be more beneficial if you filed for personal bankruptcy rather than business bankruptcy. (To help you with the considerations, we cover the three bankruptcy chapters in detail below.)

Benefits of Filing for Bankruptcy

Bankruptcy can seem like a scary, doomsday alternative. But companies and individuals file for it every day.

There are some great advantages to filing for bankruptcy:

  • You get an automatic stay. When you file for bankruptcy, you'll immediately be awarded an automatic stay. An automatic stay stops your creditors from taking your property or collecting any money on your debts for as long as you're in bankruptcy court. The automatic stay can buy you time, if nothing else.
  • Wipes out most unsecured debts. In personal bankruptcy, many of your unsecured debts—like, medical bills, credit card debt, and some lawsuit judgments—will be discharged.
  • Some property will be exempt. You might think that, when you file for bankruptcy, you'll lose everything you own. That isn't true. Some property or equity in the property—for instance, some home equity, clothes, and furniture—will be protected by state law. Your protected property can't be taken by creditors.
  • Your debt will be resolved. Whether your debts are paid off or discharged or your creditors agree to a repayment plan, there's a path forward. At that point, your creditors will be on board and you'll have the court's backing. So, you're no longer dealing with your debt alone.

Chapter 7 Bankruptcy

If you're looking for a way to close one chapter and start anew—whether you're a business or individual—Chapter 7 bankruptcy can help.

Who Can File for Chapter 7 Bankruptcy?

Both businesses and individuals can file for Chapter 7. It's a useful option for businesses that are looking to close and pass off the burdensome task of liquidating the business. For individuals, Chapter 7 can discharge qualifying debt and offer a fresh start.

Any business can file for Chapter 7, but the business owner should understand that all of the business assets will be sold. So, Chapter 7 business bankruptcy won't make sense for business owners unless they're looking to close their business.

While any business can file for Chapter 7, not every individual qualifies. Individuals who have more personal (or "consumer") debt than business debt must pass a means test to be eligible to file. (11 U.S.C. §707 (2022).)

The means test determines whether your income is low enough to qualify. If it is, then you can go forward with the Chapter 7 filing. If it isn't, then you'll have to consider other bankruptcy options.

How Does Chapter 7 Bankruptcy Work?

In a Chapter 7 bankruptcy, a trustee is assigned by the court to sell your assets and pay your debts. The trustee will set aside any secured property and exempt assets you have and sell the remaining nonexempt property.

Your state defines what qualifies as exempt. Most states allow you to keep some equity in your home, which can end up saving it. Because Chapter 7 is meant to give you a fresh start, you're usually allowed to keep the basics.

The trustee usually has two kinds of creditors to satisfy: secured and unsecured. Your trustee will satisfy secured creditors' debts using the property that secured the loan, called the collateral or secured property.

To fully satisfy the secured creditors' claims, the trustee will either:

  • sell the secured property and pay secured creditors in full with the proceeds from that property, or
  • surrender the property to the secured creditors.

The trustee will usually sell the secured property when it's worth more than the debt owed. By selling the secured property, the trustee can pay back the secured creditor in full and have money left over to disburse to unsecured creditors. If the trustee returns the property to the creditor, then the debt is satisfied regardless of how much the property is worth.

For instance, if Hugo owes $2,000 on a secured loan and returns the secured property worth $1,000 to the creditor, then Hugo no longer owes the secured creditor any money. Even though the secured creditor will be reclaiming property that's worth less than the loan, the bankruptcy court will consider the debt settled.

With the secured creditors satisfied and your assets sold, your trustee will pay your unsecured creditors next. The trustee will first pay priority unsecured creditors and then general unsecured creditors. Any qualifying debt will be discharged.

Types of common dischargeable debt include:

For example, imagine Steve has $2,000 in medical bills, $3,000 in student loans, and $2,000 left of a secured loan on a car worth $6,000. The trustee sells the car and uses the $6,000 to pay off the secured loan. The medical bills are discharged. So, the trustee uses $3,000 of the remaining $4,000 from the sale of the car to pay off the student loans, leaving Steve with $1,000.

If you're a small business owner or corporate shareholder, you're better off filing for personal Chapter 7 bankruptcy than business Chapter 7 bankruptcy to take advantage of debt discharge. Importantly, businesses can't discharge their debt, which is a critical reason why most close after filing.

You'll benefit most from Chapter 7 if you don't have many assets. If you don't have much property, then you don't have much to lose. You can get rid of some debt and make financial recovery a little easier.

Chapter 7 bankruptcy is significantly different from Chapters 11 and 13 (which we cover below). Notably, debtors filing for Chapter 7 are looking to wipe their slates clean and to get rid of their debts immediately, while debtors in Chapter 11 and 13 are trying to address their debts over time so that they don't have to start back from scratch. For more information, read about the other important differences between Chapters 7 and 11 and between Chapters 7 and 13.

Does Chapter 7 Bankruptcy Clear All Debt?

The short answer is no. It will, however, clear most debt. But don't expect to leave all debts behind.

You should be able to satisfy your debts with secured creditors by giving up any collateral you used to secure the loans. If you've decided to keep your collateral and the secured creditor agrees to let you do so, then your loan will survive bankruptcy. (You usually have to agree to continue making payments on the loan for the creditor to agree in this situation.) After your case is done, you're still be responsible for paying back any secured loan when you keep the collateral.

For instance, assume Dana has $4,000 in medical bills and $1,500 in credit card debt. She has a $5,000 secured loan on her car, which is worth $3,000. Knowing that bankruptcy will wipe out her medical bills and credit card debt, Dana believes that she can now afford to make her car payments. The lender—realizing the loan is worth more than the car itself—agrees to let Dana keep her car if she keeps making payments. As promised, Dana continues making payments on her car after her bankruptcy case ends.

Most unsecured debt will be discharged in bankruptcy. If your debt is discharged, you won't be liable for it after bankruptcy. But you'll need to pay back any remaining unsecured debt that isn't discharged in bankruptcy.

Common nondischargeable debt debt can include:

  • some kinds of taxes
  • child support and alimony
  • court fines and penalties, and
  • student loans.

Again, business debt isn't dischargeable. Businesses—and individuals who are sole proprietors or who have made personal guarantees—will still be liable for any business debts that remain at the end of their business bankruptcy case.

You can only discharge business debt if you've given a personal guarantee for the business loan or are a sole proprietor and you've filed for personal bankruptcy. When you file for personal bankruptcy, the court looks at your personal debts and determines which of these debts can be discharged.

As a sole proprietor, your business debt is considered your personal debt and the bankruptcy court would treat the two types of debt as the same. If you personally guaranteed a business loan—regardless of your business structure—then the personally guaranteed business loan would be considered a personal debt and potentially dischargeable in personal bankruptcy.

Chapter 11 Bankruptcy

While Chapter 7 is used for businesses looking to dissolve, Chapter 11 is used for businesses that want to remain open. So if you're a business owner who wants to stay in business, wants to file for bankruptcy, and doesn't want to file for personal bankruptcy, Chapter 11 is your best option.

Who Can File for Chapter 11 Bankruptcy?

Businesses and individuals can both file under Chapter 11 bankruptcy. However, because Chapter 11 is used as a reorganizing tool for businesses and Chapter 13 is available to both businesses and individuals, it's more common for businesses to file under 11.

Individuals whose income is too high to qualify for Chapter 7 and whose debts are too high to qualify for Chapter 13 will need to file under Chapter 11.

How Does Chapter 11 Bankruptcy Work?

Unlike in other bankruptcies, a trustee isn't assigned in Chapter 11 bankruptcy. Instead, you remain in control of your business and assets.

You'll work with your creditors and the court to come up with a repayment plan—known as a plan of reorganization—and the plan will usually cover a three- to five-year payment period. There aren't many rules to follow, and as long as the creditors and court agree, you can craft your plan to fit your needs.

However, you'll need to prove to your creditors and the court that you can afford your proposed plan before they'll approve and confirm it. Make sure your plan is reasonable and attainable. Don't promise to repay a debt in two years if you'll likely need five.

You might decide to keep all of your assets or to sell some or all of them. Most businesses choose to keep their assets because they're critical for business operations to continue.

Chapter 11 bankruptcy cases can take just a few months or a few years—depending on the complexity of the debts and reorganization plan—from the time you file to the time the court and creditors approve your reorganization plan. Some small businesses can qualify for a faster case (under Subchapter V), which can save you time and money. But this streamlined process requires more oversight and less flexibility.

Does Chapter 11 Bankruptcy Clear All Debt?

The answer is complicated. When a court approves your reorganization plan, the debt is considered discharged because the plan replaces the debt, essentially removing it. But in the context of Chapter 11 bankruptcy, "discharged" doesn't mean "dismissed." You must still follow the proposed payment schedule laid out in your plan to satisfy your debts.

Under your plan, some debts might be paid in full, some paid partially, and some eliminated. Your plan can also change or delay due dates for payments and decrease the interest rates on loans. For example, you might be able to lower a 7%-interest bank loan to 5% interest and give yourself 60 days to make your next student loan payment rather than 30 days.

You can wipe out a debt in a Chapter 11 reorganization plan as long as:

  • the court approves of the discharge, and
  • the creditors approve (by a vote) of the discharge.

(11 U.S.C. §707 (2022).)

If you're a business, the court will typically dismiss all remaining debt once your plan is confirmed. If you're an individual, the court will usually wipe out your remaining debt once it has determined you've completed your payments outlined in your plan.

Chapter 13 Bankruptcy

Chapter 13 can be a good option for business owners and corporate shareholders to file for personal bankruptcy. If you can get rid of some personal debt, it may free up funds for you to finance your business. While business debts can't be discharged, with Chapter 13, you can discharge any business loans you signed for as a personal guarantee.

Who Can File for Chapter 13 Bankruptcy?

Only individuals and sole proprietors can file under Chapter 13. Businesses can't file under Chapter 13.

You're eligible to file as long as your debts combined (secured and unsecured) are less than $2.75 million. (11 U.S.C. §109(e) (2022).)

How Does Chapter 13 Bankruptcy Work?

Chapter 13 works similarly to Chapter 11, where you propose a repayment plan to last three to five years. You again need to prove that you can afford the repayment plan for it to be approved. As with Chapter 11, you get to keep your property.

Unlike in Chapter 11, a trustee is assigned to Chapter 13 bankruptcy cases. You make monthly payments to the trustee, and they'll use that money to pay back your creditors.

Does Chapter 13 Bankruptcy Clear All Debt?

You'll likely only have to pay a small portion of unsecured debt under Chapter 13. Qualifying debts will be discharged, which could potentially include personally guaranteed business debts.

Your business debts won't be discharged because you're filing for Chapter 13 as an individual for personal debts. (And bankruptcy doesn't usually discharge business debts anyway.) So you'll need to come up with a plan to pay off those debts.

You can try negotiating with creditors to lower your business debt. But rest assured, your business creditors can't come after you personally if you've already addressed their claims in your bankruptcy case.

But what happens if you can't pay a personal debt under your payment plan—if, for instance, you've lost your job or are injured and temporarily unable to work? If you're not able to make your payments and want to avoid your case getting dismissed, you have a few options:

  • propose a change or new plan to the court
  • ask the trustee to give you more time, or
  • switch to a Chapter 7 filing.

Get Help Dealing With Business Debt

For more information on handling business debt, see our section on small business bankruptcy. In the end, if you're seriously considering bankruptcy, you should get in touch with a knowledgeable small business attorney with bankruptcy experience. They can help you choose the right bankruptcy filing and guide you through the process.

You can also consult a small business attorney about the option of trying to save your business by selling most or all of your business assets outside of bankruptcy to have more cash on hand for operating expenses. (With this approach, when everything else has failed, you might have to sell your business.)

Talk to a Lawyer

Need help? Start here.

How it Works

  1. Briefly tell us about your case
  2. Provide your contact information
  3. Choose attorneys to contact you
Get Professional Help

Talk to a Business Law attorney.

How It Works

  1. Briefly tell us about your case
  2. Provide your contact information
  3. Choose attorneys to contact you