LLC Bankruptcy: A Professor’s Take on Why Limited Liability Doesn’t Always Protect You

As a practicing attorney with 26 years of experience, I can tell you that the single most common mistake small business owners make is believing their Limited Liability Company (LLC) offers complete protection from personal financial ruin. The ‘limited liability’ wall is often an illusion. In bankruptcy court, the debt is rarely just the business’s problem.

You need to understand the critical nuances of the personal guarantee that can force you, the owner, into a personal Chapter 7 or Chapter 13 filing, even if your business is an LLC. (limited liability company).

By Alexander Hernandez, J.D., Professor, and Author of Consumer Bankruptcy Law (Routledge).

Listen: The Professor’s Audio Briefing.

Key Points on Bankruptcy for Business Owners:

• The Personal Guaranty: For small-to-mid-sized businesses, the personal guarantee required by lenders on nearly all commercial loans immediately overrides the protection offered by the LLC structure.
• Chapter 13 is for Individuals Only: Businesses (including LLCs) cannot file for Chapter 13. This reorganization chapter is strictly limited to individuals with regular income who meet specific debt limits (11 U.S.C. § 109(e)).
• Federal vs. State Law: While the LLC is based on state law, bankruptcy is governed by federal law (the U.S. Bankruptcy Code).

What You Need to Know About Bankruptcy For Your Business LLC or Limited Liability Company

An LLC is the most popular form of small business entity, offering flexibility and what’s known as “pass-through” taxation, where tax liability transfers to the owner’s personal tax return. Crucially, the LLC is designed to shield the owner’s personal assets from the business’s operational debts (e.g., a slip-and-fall lawsuit).

When teaching my business law students, I use the analogy that if you invest $25,000 into your business, the liability of your personal savings is generally limited to that $25,000 equity investment.

However, this protection hinges on one assumption: that you never personally guaranteed the business’s debts.

The Critical Role of the Personal Guaranty

You may have registered your LLC, secured your Employer Identification Number (EIN), and opened your business bank account correctly. But the moment you signed your business loan or commercial lease, you likely became personally liable for the debt.

The common practice among banks and lenders is to require the owner to sign a Guaranty Clause. This specific section in the loan documents establishes a separate contractual obligation between you, the individual, and the lender.

Debt-Free Journey: Embracing the Time Factor

The Professor’s Take: When starting up, banks need to protect their investment since the business often has no established assets or profitability. They can only mitigate this risk by requiring the owner to put their personal credit and assets on the line. Look for terms like “Unconditional Guaranty” or “Waiver of Limited Liability” in your documents.

Once this document is signed, the bank treats that business debt no differently than your personal mortgage or credit card debt. If the business defaults, the creditor will sue you to collect.

Navigating Bankruptcy Chapters for an LLC

When an LLC fails, the decision on which bankruptcy chapter to file depends entirely on the owner’s goal: closing the business or attempting to reorganize it.

If the Goal is to Close the Business: Chapter 7

If the LLC is insolvent, the owner will typically file a personal Chapter 7 bankruptcy.

• The Dual Filing Myth: Some bankruptcy attorneys may advise filing Chapter 7 for both the individual and the business. This is rarely necessary if the business has few assets. Since the LLC’s major debt is personally guaranteed, the individual’s Chapter 7 (a liquidation under 11 U.S.C. § 701 et seq.) is generally sufficient to discharge the owner’s liability for those business debts.
• Creditor Actions: Once you receive a discharge in your personal Chapter 7, the creditors who hold the personally guaranteed debt are legally barred from pursuing you. The business may simply dissolve under state law.

If the Goal is to Keep the Business Open: Chapter 11

If the business remains profitable and viable, Chapter 11 (Reorganization) is the appropriate filing.

• Subchapter V for Small Businesses: For many small LLCs, the Small Business Reorganization Act (SBRA), codified as Subchapter V of Chapter 11, has made reorganization more accessible and less expensive. This allows the business to restructure debt while the owner maintains equity and control.

2022 Bankruptcy Filings Data

Understanding the scope of business bankruptcy filings provides important context. The data below illustrates the reality that business filings are a minority of all bankruptcy cases, emphasizing that the LLC structure does not stop the filing process.

Chapter	Total Cases Filed (2022)	Non-Business Cases	Business Cases
Chapter 7	225,455	217,727	7,728
Chapter 13	157,087	156,060	1,027
Chapter 11	4,918	453	4,465
TOTAL	387,721

Data Source: Table F-2, U.S. Bankruptcy Courts—Business and Nonbusiness Cases Commenced, 12-Month Period Ending December 31, 2022. You can view the full report from the bankruptcy court by clicking this link.

Bankruptcy Chapter	Who Can File?	Purpose	Outcome for Owner’s Debt (via Guarantee)
Chapter 7	Individuals & Businesses	Liquidation/Discharge	Discharges personal liability for guaranteed debt.
Chapter 13	Individuals Only	Reorganization (Payment Plan)	Used to restructure personal/guaranteed debt over 3-5 years.
Chapter 11	Businesses (Mostly)	Reorganization (Business continues)	The business debt is restructured; the personal guarantee may still require separate negotiation.

The Professor’s Conclusion: The Limits of Limited Liability

The Limited Liability Company (LLC) is an essential tool for asset protection and taxation, but it is not a shield against personal liability for guaranteed business debt in bankruptcy. The core legal principle remains: you are only protected when you do not personally guarantee the business obligation.

If your business is struggling, seeking advice from an attorney who specializes in both business law and consumer bankruptcy is essential to avoid compounding legal errors.

Colleges and universities can purchase my bankruptcy law textbook directly from Routledge Publishing. Paralegals and students who are buying single copies can do so via Amazon Books. To access my YouTube channel, click this link. You can also listen to my podcast on Spotify.

You can learn more about filing for bankruptcy and the bankruptcy petition via this link. Information on the bankruptcy court system, contact information for trustees, and your state’s exemptions can be found here. The federal bankruptcy exemptions are listed here. The latest version of the 341 Meeting of the Creditors can be found here.

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