Are You Personally Liable for Your Business's Debts? (2024)

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.

• When Are You Liable for Your Business's Debts?
• How Your Business Structure Affects Your Personal Liability
  • Unlimited Liability: Sole Proprietors and General Partners
  • Limited Liability: Corporations and LLCs
• What's the Difference Between Secured and Unsecured Debt?
  • Debt Secured By Collateral
  • Debt Secured By a Personal Guarantee
• Situations Where You Risk Your Limited Liability
• Is Your Business Responsible for Your Personal Debts?

When Are You Liable for Your Business's Debts?

You are personally liable for your business debts under the following circ*mstances, which we cover below:

• You are a sole proprietor or a general partner in a partnership.
• You personally guarantee the debt.
• You fail to make certain business tax payments.
• You fail to maintain your corporation or LLC properly and lose its limited liability protection (the "veil" is "pierced").

Business debts include loans, leases, trade credit (accounts payable), and judgments against you in lawsuits. If you are personally liable for a business debt, you are on the hook for it if your business fails to pay.

How Your Business Structure Affects Your Personal Liability

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.

Unlimited Liability: Sole Proprietors and General Partners

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 reach 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% 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 reimbursem*nt.)

Limited Liability: Corporations and LLCs

If your business is organized as a corporation or LLC, you and your business are separate legal entities. As a shareholder of a corporation or a member of an LLC, you aren't personally liable if your business can't pay its debts. In other words, you have LLC limited liability or corporate limited liability protection. You have this protection as long as:

• The debt is business-related, meaning that it was incurred by the business for legitimate business purposes. If you purchase an item for personal use through your business and you take on debt to make the purchase, you will be personally liable for the debt and the creditor will be able to claim that asset if you fail to pay.
• The debt isn't secured by a personal guarantee or the pledge of personal assets as collateral.
• You haven't lost your corporate or LLC limited liability protection for one of the reasons stated below.

What's the Difference Between Secured and Unsecured Debt?

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 isn't robust and financially secure. In this situation, the personal guarantee secures the loan.

A loan, line of credit, or purchase that's made with no such condition is unsecured debt. This kind of debt isn't secured by a personal guarantee or collateral (property that you've pledged in exchange for the loan). If a business debt is unsecured, the creditor is out of luck if the business defaults on the debt. For this reason, most business debt is secured by a pledge of collateral or a personal guarantee.

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. If you fail to make your payments, you can (and likely will) forfeit your car.

Debt Secured by 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 car 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.

Debt Secured by a Personal Guarantee

When you're a small business owner, many creditors will require you to personally guarantee your business's debts. Banks might require you to co-sign or personally guarantee a loan, and many leases require personal guarantees.

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.

Situations Where You Risk Your Limited Liability

As signaled 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 this kind of owner's personal assets, which is known as "piercing the corporate veil" (more examples below).

Here are some additional exceptions to limited liability faced by all business types.

The Business Doesn't Pay Employee Withholding Taxes

If your business has employees, you are required to withhold taxes from your their 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 Override Limited Liability

Each state sets its own rules for corporations and LLCs, including when it comes to liability exceptions. 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.

For example, a court in Arizona found that members of an LLC in Arizona can be held personally liable if the company fails to pay privilege tax (a type of sales tax). State ex rel. Arizona Department of Revenue v. Tunberg, 464 P.3d 688 (Ariz. App. Div. 1 2022)

States can amend their rules through legislation and court rulings, so it's important to keep abreast of changes.

You Signed a Contract 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 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." The contract should say that it is "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 to the point it can't pay for the fall merchandise shipment. The way you entered into and signed the purchase agreement could make 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. Again, this situation is known as "piercing the corporate veil." Some examples are:

• The corporation fails to hold annual meetings and keep minutes documenting important decisions as required by law.
• LLC members pay their personal bills using the LLC checkbook, or they pay LLC bills out of their personal checkbook.
• A corporate shareholder or LLC member misrepresents or lies on an application for a loan or credit on behalf of the company.
• An LLC member or shareholder commits a criminal act, such as being convicted of stealing money from the company.

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, meaning that you don't have limited liability.

Is Your Business Responsible for Your Personal Debts?

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're 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.