Business debts that you share with another person—a spouse, partner, or cosigner—can raise some legal issues if you can't pay them, especially if you eventually consider filing personal bankruptcy to get rid of your business debt.
Whether you are liable for your spouse's business debts, or your spouse is liable for yours, depends mostly on where you live.
In "community property" states, including California and Texas, generally any debt incurred by one spouse during marriage (but before separation) is owed by both spouses. Likewise, in these community property states, all income made by either spouse during marriage, as well as property bought with that income, is community property, owned equally by husband and wife. This means that the business creditors of one spouse can go after the assets and income of the community (the married couple) to make good on that spouse's debt. (It follows that if that if only one spouse were to file for Chapter 7 bankruptcy in a community property state, all of the eligible debts of both spouses would be discharged.)
Community and Common Law Property States
|*In Alaska, couples can elect to treat their property as community property|
|**In California, community property laws also apply to registered domestic partners.|
EXAMPLE: Linda runs a fabric store in Houston, Texas; her husband is a local bank executive. Over the last few years, Linda's store has been suffering from poor sales, but the recession is the final nail in the coffin, as people all but stop spending money on customizing their houses. Linda closes her doors owing $35,000 to suppliers, $15,000 to her landlord, and $10,000 in other invoices.
Because Linda and her husband live in a community property state, these creditors can sue both Linda and her husband personally to collect the money owed. Linda no longer has an income to take, but her husband's is significant, and her creditors are able to garnish $5,000 of her husband's income per month until the debts are paid off.
You can agree to keep property separate. Couples in community property states can sign an agreement with each other to have their debts and income treated separately. This can prevent your spouse from being liable for your business debts. Signing an agreement now won't help your spouse escape personal liability for business debts that you already owe, but signing an agreement now (and then scrupulously keeping your assets separate) can protect your spouse from future business debts. See a lawyer with experience in postnuptial agreements for help in drafting this type of agreement.
In states that don't have "community property" laws (sometimes called "common law" property states), business debts incurred by one spouse are that spouse's debts alone. Debts are jointly owed only if 1) the debt was jointly undertaken—for example, if both spouses signed a contract requiring them to make payments—or 2) if the debt benefits the marriage (for example, the debt was for food, clothing, child care, or necessary household items).
Otherwise, business creditors of one spouse cannot legally reach the other spouse's money, property, or wages to repay a spouse's separate debt. However, if both spouses' income has been put into one joint account, a creditor may have the right to take at least 50% of the money from the joint account to pay a separate debt. In addition, the law of some common law states also provides that if you and your spouse jointly own property, such as a house, but a business debt is yours alone, the creditor cannot force a sale of the property by attaching a lien to it. (As to bankruptcy, if you alone (not your spouse) were to file for Chapter 7 bankruptcy in a common law state, only your separate debts and your joint debts will be discharged; your spouse's separate debts would not be discharged.)
EXAMPLE: Will 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. After a few years of strong construction rentals, Will's business drops off steeply as housing starts disappear. Will markets his party rentals heavily to help tide him over and tries to lower his debt costs by selling some of the construction equipment that is sitting idle. But after not being able to pay some of his bills for several months, a creditor is threatening to sue the Hortons.
Fortunately, because the Hortons don't live in a community 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" and live in New York, a creditor cannot put a lien on the house and force its sale as long as Amanda is alive. If Amanda and Will were to sell the house, however, the creditor would have to be paid off with Will's half of the proceeds.
Keep what's separate, separate. If you live in a common law state, you absolutely don't want to have your spouse personally guarantee your business debts. Unless your spouse cosigns a loan or personal guarantee, your spouse can not be held liable for your business debts if you keep your income separate (in a common law state).
All partners are personally responsible for all of a general partnership's debts. And because each partner has the legal power to obligate the partnership, creditors can come after your personal assets to collect on a debt even if another partner signed the deal and you did not. What does this mean for bankruptcy? If you were to file for individual Chapter 7 bankruptcy, you could get rid of your personal liability for the partnership debts, but the remaining partners would still be on the hook for 100% of the partnership's debts, unless they too filed for bankruptcy.
EXAMPLE: Adam and Steve, acquaintances from a Master's program in geology, form a partnership to assess and repair damage to California streams. They take out a $40,000 equipment loan, which Steve's parents cosign. Over a few years, they build a successful business by getting contracts from state and federal agencies.
But when the state suffers economic woes, payouts are frozen for three months, and 75% of Adam and Steve's jobs are cancelled. They try to continue business as usual, fearing they'll lose their employees forever if they lay them off. But after the money isn't unfrozen in month four, they begin to cut payroll, sell equipment, and sublet unused office space. Unfortunately, they are so far in the red by now that they can't make their loan payments or pay suppliers. With their backs to the wall, they decide to lay off their entire workforce and hibernate the business until the government is paying again.
As business partners, Adam and Steve are each personally liable for all of the business debts. Their main supplier sues over a $40,000 debt, and because there is no money left in the business, goes after Adam and Steve (and Pam, Steve's wife) personally to pay the debt. Steve has no income now, but Pam does, and the supplier can go after it because they live in a community property state and Pam is equally liable for the debt. After getting a court judgment against Adam, Steve, and Pam, the supplier garnishes 25% of Pam's paycheck.
Steve and Pam decide to file for Chapter 7 bankruptcy, meaning both spouses' debts will be discharged and Pam's paycheck will no longer be garnished. Most important, they can keep their house, since they have only $75,000 in equity in it, the amount exempt from creditors in their state. (See Nolo's article What Can Creditors Do If You Don't Pay?) After Steve and Pam's bankruptcy, Adam is still 100% liable for the supplier's debt. Because he owns assets that are not exempt and that creditors may take, including a vacation house, he takes out a second mortgage on the vacation house and pays the supplier.
The partners also default on the $40,000 equipment loan, but Steve's liability for it was discharged in bankruptcy, making Adam 100% liable for it, along with Steve's parents, who cosigned the loan. Adam refuses to pay, claiming that since he made good on the supplier's debt, he considers his half of the partnership debt paid. Eventually Steve's parents, the cosigners, pay off the loan rather than risk being sued and losing their house (but if they hadn't, the equipment lessors could have sued either Adam or Steve's parents or both).
Cosigners and guarantors legally guarantee that they will make debt or loan payments if you or your business don't pay off its oan. Because the cosigner or guarantor signed a personal guarantees, it makes no difference whether your business is organized as a sole proprietorship, partnership, LLC, or corporation -- the cosigner or guarantor has to pay the business's debt.
Unfortunately, even if you, the business owner, were to get out of paying a debt—say you file for Chapter 7 bankruptcy and get your liability wiped out by the court—your consignor or guarantor would still be legally on the hook to pay it. If this were to happen, you might not want to stick the cosigner or guarantor with the debt you just escaped (many close relationships have been ruined this way).
Inatead, you could legally "reaffirm" the debt in bankruptcy—basically, promise to repay it—and keep making payments after bankruptcy. Another option would be to make an informal arrangement with the cosigner or guarantor to eventually repay any amount they pay your creditor. Or you could file for Chapter 13 (repayment) bankruptcy instead; in that case, the cosigner would not be called to account until you completed your repayment plan, three to five years down the road.
Learn more about personal liability for business debts.