When you take out a loan in your business name, you probably plan on having enough steady revenue to cover the payments. When the unexpected happens — sales drop off, expenses skyrocket, or you deplete your rainy day fund — your business may not be able to shoulder the burden the way you’d hoped. If your company can’t pay and ends up defaulting on the loan, you as the owner might be held personally liable for the repayment. However, every situation is different, and personal liability is not automatic. It will depend on the entity type you choose to operate your company and the business structures you have in place, as well as whether you agreed to be responsible for repayment when you first took out the loan.
What Does It Mean to Be Personally Liable?
When you are personally liable for a business loan, it means that the lender can demand repayment from you as an individual for your business’s debts, separate from your company. They may try to recover their losses by:
- Sending you bills and invoices
- Submitting adverse reports about your account to the consumer credit bureaus while you are in default
- Turn your account over to a third-party debt collection agency
- Take you to court and try to get a judgment in their favor. The court could then order you to repay the loan or give the lender the right to garnish your wages or your bank account.
- Repossessing assets that were put up as collateral
How Your Business Structure Affects Your Liability
Certain business types have inherent protections that shield you as the business owner from personal liability, while others don’t.
Additionally, adhering to corporate formalities, such as keeping separate financial records and holding regular meetings, is crucial to maintaining these protections.
Sole Proprietorship
If you haven’t formally established your firm as a separate legal entity, it’s considered a sole proprietorship. You and your business are interconnected, meaning no distinction would protect your assets as an individual. With a sole proprietorship, you’re liable for the debts your business incurs. Your creditors could go after your house, car, or other property if your business lacks adequate assets to satisfy the debt.
Partnership
A business that two or more people own is considered a partnership. The amount of personal liability you have for business debts will depend on the specific partnership type you’ve formed.
- General partnership — When two people are in business together, even if they created no formal entity, it is considered a general partnership. General partners are personally liable for their business obligations.
- Limited partnership — A limited partnership includes one or more limited partners and one or more general partners. A general partner is held accountable for outstanding business loans, while a limited partner is not.
- Limited liability partnership (LLP) — When you set up an LLP, the limited partners are shielded from personal liability. In certain states, an LLP will need to have at least one general partner who can be held personally liable if necessary, and some states apply liability protections only to negligence claims — not to business debts.
Corporation
The purpose of an incorporated business entity is to limit its owners’ personal financial accountability, protecting corporate shareholders from personal liability. Corporation owners, or shareholders, do not have to personally pay back an unpaid business loan if they managed the business properly. Unless there was a commingling of funds or a shareholder agreed to be held liable for the loan, the only way a creditor can recoup their funds is through the corporation’s assets.
Limited Liability Company (LLC)
Owners, or members, of an LLC, have much the same legal protection as shareholders in a corporation. Members will generally not be held personally liable for business debts unless they improperly mixed personal and business funds or offered a personal guarantee for loan repayment.
What Is a Personal Guarantee?
Even if your business entity is set up to protect you from personal liability, your bank may ask you to make a personal guarantee — a pledge that you will pay the funds back if your company can’t. This is especially common if your small business doesn’t have the solid financials or credit history it needs to stand on its own. High personal credit scores and possession of non-business assets that you can use as collateral for the loan will strengthen your personal guarantee — and your loan application in general. Putting your home or other property on the line can feel like a gamble, but this is often the only way for small business owners to acquire a traditional bank loan.
Types of Business Debt
Business debt can be categorized into two main types: secured debt and unsecured debt. Understanding the differences between these two types of debt is crucial for business owners to manage their finances effectively and minimize their personal liability.
Secured Debt: Debt Secured by Collateral or Personal Guarantee
Secured debt is a type of debt that is backed by collateral or a personal guarantee. This means that if the business defaults on the loan, the lender can seize the collateral or hold the business owner personally liable for the debt. Examples of secured debt include:
- Business loans secured by property or equipment
- Mortgages on commercial real estate
- Leases on equipment or vehicles
- Personal guarantees on business loans or credit cards
Secured debt can provide businesses with access to capital at a lower interest rate, but it also increases the risk of personal liability for the business owner. When you offer collateral or a personal guarantee, you are putting your personal assets on the line, which can be a significant risk if your business faces financial difficulties.
Unsecured Debt: Debt Not Secured by Collateral or Personal Guarantee
Unsecured debt, on the other hand, is not backed by collateral or a personal guarantee. This type of debt is typically offered to businesses with a good credit history and a stable financial situation. Examples of unsecured debt include:
- Business credit cards
- Unsecured business loans
- Lines of credit
- Accounts payable
Unsecured debt can provide businesses with flexibility and convenience, but it also carries a higher interest rate and a greater risk of default. Without collateral, lenders rely more heavily on the business’s creditworthiness, which can make it harder to obtain unsecured loans if your business’s financial situation is less than ideal.
Situations That Risk Limited Liability
While limited liability companies (LLCs) and corporations provide business owners with limited liability protection, there are certain situations that can risk this protection. Business owners should be aware of these situations to minimize their personal liability.
Failure to Pay Employee Withholding Taxes
One situation that can risk limited liability is the failure to pay employee withholding taxes. Business owners are personally liable for unpaid employee withholding taxes, regardless of the business entity type. This means that if the business fails to pay these taxes, the business owner can be held personally liable for the debt.
To avoid this situation, business owners should ensure that they are paying employee withholding taxes on time and in full. They should also maintain accurate records of these payments to demonstrate compliance with tax laws. Failing to do so can pierce the corporate veil, making you personally responsible for the business’s debts.
By understanding the types of business debt and the situations that can risk limited liability, business owners can take steps to minimize their personal liability and protect their personal assets. This proactive approach can help safeguard your financial future and ensure that your business remains a viable and thriving entity.
Reducing Your Personal Liability
What if you don’t have the resources to pay for your company debts personally? Thankfully there may be a way for you to reduce or even eliminate your personal liability. Strategies to consider include filing for bankruptcy or attempting to renegotiate your debt.
Filing for Bankruptcy
If you qualify to file for Chapter 7 bankruptcy, your individual debts will be discharged, and you will not have to pay for your business-related debts personally. You will likely lose assets and have difficulty acquiring additional funding while the bankruptcy is on your credit report, so weigh your options carefully before filing for Chapter 7.
Renegotiating Your Debt
The lender trying to secure repayment may be open to negotiations if it becomes apparent that they will not receive the loan’s entire outstanding balance. Getting a partial payment is better than no payment at all, so lenders are sometimes willing to reduce a borrower’s personal liability. The lender may be willing to:
- Offer a balance reduction — Creditors will sometimes forgive a portion of a debt in exchange for a smaller lump sum payment upfront.
- Renegotiate the loan repayment terms — A lower interest rate or a longer payback duration could be enough to bring your monthly payments down to a manageable level.
