Bankruptcy and LLCs: An Essential Guide for Owners
Are you losing sleep worrying about business debt and how it might affect your personal life? You’re not alone. Many business owners struggle to understand how their personal assets and business debts are related, especially when issues like bankruptcy and LLCs come into play. The interplay between bankruptcy and LLCs can be tricky, so business owners must understand the implications of filing personal bankruptcy.
You formed a limited liability company (LLC) to shield yourself from business liabilities, but what happens when your business can’t pay its bills? Are your personal assets really protected, or could you still lose everything? Let’s examine what happens if you find yourself considering filing bankruptcy.
LLCs: A Quick Refresher
A limited liability company, or LLC, is a popular type of business structure. It is a separate legal entity from its owners, often called members.
This separation offers limited liability protection. It means that, in general, the members aren’t personally liable for the business’s debts and obligations.
Think of it like this: if your LLC gets sued or can’t pay its business debts, creditors can typically only go after the LLC’s assets. Your personal assets, like your house, car, and savings, should be safe—in theory.
When the Protection Fails: Piercing the Corporate Veil
The limited liability protection that LLCs offer isn’t absolute. Creditors can try to “pierce the corporate veil” and come after the personal assets of LLC members.
They would argue that the LLC structure shouldn’t protect you due to certain actions. These situations often arise in bankruptcy cases when creditors look to recover business debts.
There are many different ways piercing the corporate veil may come into play. This is a crucial aspect of bankruptcy law that every LLC member should understand to protect their personal finances.
Common Reasons for Piercing the Corporate Veil
What actions can lead to losing your liability protection? A few common scenarios exist. Understanding them is essential for protecting your assets and for navigating bankruptcy and LLCs effectively.
- Commingling Funds: Mixing personal and business funds makes it hard to tell where the LLC ends and your personal finances begin. This is a common issue that can jeopardize the limited liability protection.
- Under capitalization: Failing to provide the LLC with sufficient capital to meet its reasonably anticipated obligations may trigger personal liability. Make sure your LLC has enough capital for its needs.
- Fraudulent Activities: If you use the LLC to commit fraud or other illegal activities, expect the courts to disregard the liability shield. The court may remove limited liability if there is any indication of such.
- Failure to Observe Corporate Formalities: Failing to operate your LLC as a separate legal entity could invite liability. This could include things like not holding regular meetings.
- Personal Guarantees: Sometimes members provide personal guarantees that make them on the hook personally for the debts of the small business. Review your operating agreement to know what you are liable for.
Personal Guarantees and Your LLC
A personal guarantee is a promise you make to pay back your business’s debts personally if the business can’t.
Lenders often require personal guarantees, especially when lending to small businesses or LLCs with limited credit history.
If you’ve signed a personal guarantee, it overrides the liability protection of your LLC, making you personally liable for the debt. Be aware of the impact of personal guarantees in the context of bankruptcy law.
Credit Card Debt and Your LLC
Using personal credit cards for business expenses can muddy the waters between your personal and business finances. It could create personal liability for those debts.
Even if you use a business credit card, you may still be personally liable for the debt if you provided a personal guarantee when opening the account. Check your credit card agreements.
LLC members should avoid using personal credit card debt for business expenses, to help maintain the separation needed for liability protection. Understanding how credit card debt can affect your personal liability is crucial when considering bankruptcy.
When Can an LLC File Bankruptcy?
Just like individuals and corporations, LLCs can file for bankruptcy. The most common types of bankruptcy for businesses are Chapter 7 and Chapter 11.
Chapter 7 Bankruptcy for LLCs: Liquidation
Chapter 7 bankruptcy involves liquidating the LLC’s assets to pay off creditors. The business ceases to exist. A bankruptcy trustee is appointed to oversee the liquidation process, sell the assets, and distribute the proceeds to creditors. This offers a structured and orderly process to wind down your company.
There’s transparency that can prevent future claims about asset diversion. While Chapter 7 can provide closure, LLCs do not receive a debt discharge in Chapter 7, but the debts are uncollectible after liquidation.
An experienced bankruptcy attorney can help you determine if Chapter 7 bankruptcy is the best option for your LLC.
Chapter 11 Bankruptcy for LLCs: Reorganization
Chapter 11 bankruptcy allows the LLC to reorganize its debts and continue operating. The LLC proposes a plan to repay its creditors over time, and the court must approve the plan.
This can be a better choice than Chapter 7 if you believe your business can become profitable again with some financial restructuring.
Unlike Chapter 7, Chapter 11 lets your business continue while working through debt. Chapter 11 could allow your LLC to discharge debt after complying with the court’s repayment plan.
What Happens to LLC Assets in Bankruptcy?
In either Chapter 7 or Chapter 11 bankruptcy, the bankruptcy estate generally includes all of the debtor’s property when the bankruptcy case is filed.
The bankruptcy trustee can take possession of those assets. This could include physical property, equipment, and intellectual property.
These can also include contract rights of the LLC under certain “executory contracts.” These executory contracts are subject to certain assumptions and rejections.
Filing for Personal Bankruptcy as an LLC Member
If you’re personally liable for your LLC’s debts (through personal guarantees or piercing the corporate veil), you may also consider filing personal bankruptcy.
Filing for personal bankruptcy, either Chapter 7 or Chapter 13, can discharge your personal liability for those debts.
Deciding whether to file for bankruptcy, and which type to file, can be tricky. Consulting with an experienced bankruptcy attorney will be in your best interest. In the meantime, explore some resources below to get familiar with some things to consider.
Bankruptcy Resources
Navigating bankruptcy can be challenging. You are not alone, though, as a result of the support the US government is making.
Several governmental websites provide information regarding resources available to you when considering bankruptcy and LLCs.
These include everything from available relief to potential resources for assistance. They are:
- Bankruptcy Fees
- Bankruptcy Forms
- Chapter 7 Fee Waiver Procedures & Resources
Tax Implications of Bankruptcy for LLCs
Bankruptcy can have significant income tax implications for LLCs and their members. Canceling debt in bankruptcy can create taxable income, although there are exclusions.
The IRS has a guide to other tax-related steps that you should take if you are closing a business. You will also need to familiarize yourself with the Taxpayer Bill of Rights.
Understanding the tax implications of bankruptcy is essential for proper financial planning. LLC members should seek guidance from a tax professional or bankruptcy attorney to navigate these complex issues.
Alternatives to Bankruptcy
Bankruptcy isn’t the only option for struggling businesses. Other options include debt settlement and debt management.
Debt settlement involves negotiating with creditors to reduce the amount you owe. Debt management plans consolidate your debts and offer a structured repayment plan.
Also remember if you cannot afford an attorney, you may qualify for free legal services from the American Bar Association’s Legal Help website.
Working with a Bankruptcy Attorney
Navigating the intersection of bankruptcy and LLCs is a job for the professionals. Given the legal landscape’s intricacies, consulting with a qualified bankruptcy attorney like The Law Office of William Waldner is crucial.
An attorney can evaluate your specific situation and provide tailored guidance. It is always advisable to work with a qualified professional. They can help you understand your rights, explore your options, and protect your assets.
Table: Chapter 7 vs Chapter 11 for LLCs
| Feature | Chapter 7 | Chapter 11 |
|---|---|---|
| Purpose | Liquidation of assets | Reorganization of debts |
| Business Operation | Ceases operations | May continue operations |
| Debt Discharge | No direct discharge, but debts become uncollectible. | Potential discharge upon completion of repayment plan |
| Control | Trustee takes control | Debtor retains control, subject to court oversight |
| Suitability | Businesses with no prospect of recovery | Businesses with potential for future profitability |
FAQ
Here are some frequently asked questions regarding bankruptcy and LLCs:
- Can I protect my personal assets if my LLC files for bankruptcy?
The answer to this depends on whether you’ve maintained a clear separation between your personal and business finances. If you have a personal guarantee, you may still be at risk. - What is piercing the corporate veil?
“Piercing the corporate veil” is when a court disregards the limited liability protection of an LLC. The court then allows creditors to pursue the personal assets of the LLC members. - What happens to my LLC’s assets in bankruptcy?
In bankruptcy, the bankruptcy trustee may take possession of your LLC’s assets. This could include physical property, equipment, and intellectual property, to satisfy outstanding debts. - Should I file for personal bankruptcy if my LLC is struggling?
If you’re personally liable for your LLC’s debts, consider filing for personal bankruptcy. Doing so can discharge your personal liability for those debts, offering a fresh start. - How does debt settlement compare to bankruptcy for my LLC?
Debt settlement involves negotiating with creditors to reduce the amount owed, whereas bankruptcy is a legal process. The legal process is to liquidate or reorganize debts. Debt settlement may be a good alternative if your LLC has a chance to recover.
Conclusion
Dealing with business debts can be overwhelming. Don’t make the mistake of facing these challenges alone.
By understanding the basics of bankruptcy and LLCs and working with experienced professionals, you can explore your options and take control of your financial future. Consider exploring which approach aligns best with your interests. LLC members should understand the relationship between their operating agreements and personal liability.
Bankruptcy law can be intricate. Consulting with a bankruptcy attorney or a bankruptcy lawyer can provide peace of mind during tough financial times. Request your free consultation with William Waldner and learn more about your options for filing bankruptcy as an LLC.