Friday, February 25, 2011

Are You Liable in Personal Bankruptcy for Business Debts?

Are you (a business owner) personally liable in personal bankruptcy for business debts? This was a question I recently was asked and have been asked variations of the same question in the past. So I thought I'd share it with you in order to help others who may have similar questions. 
Let's assume the following:
  • You are about to file PERSONAL bankruptcy (Chapter 13 - reorganization or Chapter 7 - liquidation) because either your personal debts are too large or you took on personal debt for the business. In either case your personal debt far outweighs your assets and your income. 
  • Your company owes money and has been late on some payments.
  • Your company is an S-corp.
Question: My business owes other money and now I am scared that other creditors will go after me personally. Can they? Do I need to include the other business creditors in my personal bankruptcy filing? Do  I have personal liability for my business' debts?

The reason for being incorporated is to shield you personally from the company's liabilities. To maintain this shield, you must conduct your business appropriately so as not to allow the "corporate veil" to be pierced. But that is only part of the question here.

 The S-Corp. designation is for tax purposes. For legal purposes, the company is a C-corp. and is still a wholly separate entity from you. I won't go into detail as to what it means to maintain the corporate veil. Suffice it to say you need to maintain separate bank accounts, sign all company documents with your position, not just as your name (i.e., Tiffany Wright, president, Toca Family Business Services vs. Tiffany Wright), and keep corporate records of annual shareholders and directors' meetings. If you have not done this, you open yourself up to personal liability. (This opening up is what is called "piercing" the corporate veil.)

Now, if your personal financial situation is poor, you are filing for personal bankruptcy and you have NOT followed the above, you should DEFINITELY list any business creditor that you believe could have a legal right to come after you on your bankruptcy. But be careful. Chapter 13 is a restructuring, not a liquidation. So, if you are not sure, you could end up entering into a payment schedule to pay back business loans you never would have had to if you had not included them in your bankruptcy filing. If it is a Chapter 7 filing, go for it. You'll remove any threat of pursuit by business creditors now or in the future.

Here are some questions to ask?
  • Did I sign a personal guarantee on any of the loans? 
  • Did I personally guarantee any repayments to suppliers?
  • Did I sign any documents with potential creditors just as myself or pay them with a personal check or personal credit card from my own personal account? (If you only did the latter, you MUST create a paper trail, if there isn't one already, where you either get reimbursed by the company, increase the loan amount to the company, or something similar.)
If you answered "yes" to these questions, you need to include those creditors in your personal bankruptcy filing. It is highly likely that you do have personal liability for your company's debts. If not, then do not include them, unless you STRONGLY believe your business record-keeping is abysmal and can't be corrected in sufficient time.

Another thing to note: In a personal bankruptcy, creditors come after your assets. So they can pursue your shares - i.e., your stock - in the company. They can't make you make poor decisions for the company that are in favor of your personal creditors but they can threaten to pursue ownership of your stock in the company. (Remember, your business is an asset and any asset you own except your retirement accounts, your house in some states, and a few other items, are fair game.) Be aware, in a personal bankruptcy a creditor cannot takeover your business, they can only ask the judge to include it in the determination of your net worth. If the judge does and deems the business valuable enough, then you may be compelled to sell your shares in the business to generate funds to pay the creditors back. This is very difficult to do with small businesses since there is NO ready market for the shares which makes the shares extremely difficult to value AND nearly impossible to sell. So this inclusion and compelling to sell rarely happens.

The only time I recommend paying attention to a threat of pursuit of your shares is if a business owner has been taking large cash distributions from the company for some time and thus has created somewhat of a personal paper trail documenting some of the value of the stock they hold in the business AND if there are other partners, co-investors, etc. who could let the bankruptcy court (or a creditor) know that they would gladly buy the owner's shares.

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