Why LLCs Don’t Fully Protect You from Bankruptcy
If even you file for a business bankruptcy, a Limited Liability Companies (LLC) may still not be enough protect you even if Chapter 7 or Chapter 11 bankruptcy is filed. Read more to learn how you might have to file for bankruptcy personally, even Chapter 13 as a business owner because of your limited liability company.
Key Points:
- A business filing for bankruptcy usually means a personal bankruptcy may also have to be filed. An LLC won’t protect you.
- While you can file Chapter 7 bankruptcy for your business, you can’t file Chapter 13.
- Chapter 11 is another option for your business, depending on the size of your business and if it can remain profitable.
What You Need to Know About Bankruptcy For Your Business (LLC)
A common mistake I hear from clients is that they don’t have to file Chapter 7 personally because their business is a limited liability company (LLC).
An LLC, the most popular type of business classification for IRS purposes, doesn’t fully protect its owner from the business’s debts. Yes, you read that correctly. I know you have always heard the opposite, but even if your business is an LLC, you are still personally liable. How so? Let’s dig deep into this issue.
What is an LLC?
An LLC which can be with one or more owners, offers flexibility. However, the rules and regulations regarding LLCs vary per state. One key factor in LLCs is what is known as “pass-through” taxation, meaning the tax liability “passes through” or transfers from the LLC to the owner’s personal tax return; this helps avoid being taxed twice, at the business and personal level.
However, the popularity of an LLC is also due to the fact that the business structure protects the owners and investors against personal liability for the business’s debts, hence the name “limited liability company.”
I like to give my business law students the example that an LLC means if you put $25,000 into the business as an owner or partner, then your liability is limited to $25,000. So then it seems you aren’t personally liable based on that definition, correct? At least, that is how websites and accountants make it seem, but unfortunately, that’s not the case. It’s all in the fine print!
Why You Are Still Liable for Your Business Debts if You Have an LLC?
Does this sound familiar? You registered your LLC with your state, received your Employer Identification Number (EIN) from the IRS, opened up your business bank account, and the bank offered you a loan. The loan is approved, and the funds are deposited in your business account. You are now personally liable for your business’s debts! “What? Where? When did this happen?” It happened the second you signed for the loan.
Even though you took all the proper steps in setting up your LLC, there’s one basic fact endless websites on LLCs fail to state, including accountants and CPAs to their clients, and that is the bank requires that you personally guarantee the loans for the LLC. Once you personally guaranteed the debt, it is now treated no different than any other debt you have as an individual. Of course, my client’s initial reaction is that I am wrong, but unfortunately, I’m not. Let’s use a practical example to put this in perspective.
I always pose the hypothetical to clients: why wouldn’t I go to the bank and request hundreds of thousands of dollars in loans for my law practice, then turn around and file for bankruptcy and keep all the money? The answer is, of course, because I am personally liable for the debt. Not to mention, if you are starting up your business, the bank needs to protect its investment since the business has yet proven to be profitable and most likely has no assets.
The bank can only protect its investment by holding the business owner personally liable for the debts which means even though you and your business are separate, it’s really not, so that means you as the individual would need to have good credit to get a loan for your business.
Which Bankruptcy Chapter is Your Business Filing
As any lawyer will tell you, and the two words law students always hear in class, the answer is always “it depends.”
Chapter 7 and Chapter 13 bankruptcy are the two most common types of personal bankruptcy filings, and more Chapter 7s are filed than Chapter 13s.
For example, below is the total amount of bankruptcies filed in 2022; the statistics for 2023 haven’t been published yet. In total, the amount of bankruptcies filed are as follows:
- 387,721 bankruptcies were filed.
- 225,455 were Chapter 7, 157,087 were Chapter 13, and 4,918 were Chapter 11.
- Personal bankruptcy for Chapter 7 was 217,727 versus 7,728.
- Personal Chapter 13 was 156,060 versus 1,027 that were business-related.
- For Chapter 11, 453 filings were personal, while 4,465 were for businesses.
This means that of the total bankruptcies filed in 2022, 58% were Chapter 7, 40% were Chapter 13, and Chapter 11s % amounted to 1.3%.
Partial screenshot of uscourts.gov.
You can see the full report from the bankruptcy court via this link.
So What Happens with Your Business?
Now that we have reviewed that an LLC won’t necessarily protect a business owner from filing for bankruptcy, what happens with the business depends on the ultimate goal.
If the business is going to shut down, then Chapter 7 is the answer, but here is what bankruptcy attorneys won’t tell you. A bankruptcy attorney will tell you that you do have to file for personal bankruptcy because of the personal liability issue. Still, you also have to file Chapter 7 bankruptcy for your business. Why? Oh, I know, because that means the bankruptcy lawyer now has two cases instead of one, a perverse form of happy hour (2-4-1). Let me explain.
If the business is closing, when creditors go to sue the business, they can’t. The business is non-existent. You can’t sue something or someone that doesn’t exist. So, who do the creditors sue to try to get their money? You, the business owner. Remember, you are personally liable. All the business debt is transferred to you, the individual.
Chapter 7 personal bankruptcy would wipe out the debt that your business owes and you personally. There is no need to file two bankruptcies and pay twice unless you feel like spending extra money on your bankruptcy lawyer.
What if You Want the Business to Remain Open
If Chapter 7 bankruptcy isn’t the answer because you want the business to keep its doors open, then Chapter 11 is the answer, assuming the business is viable.
Chapter 11 is similar to Chapter 13 in that it is a reorganization of the debts. But Chapter 11 is complicated and expensive, so unless the business is viable and can remain open, sometimes it’s better to close the doors, file for bankruptcy, and reopen the doors to a new business. Chapter 13 bankruptcy applies to individuals, not businesses.
I hope this helps explain the issue of bankruptcy and LLCs. Best of luck with your business.
Have a question on bankruptcy? Feel free to contact me to post my reply in the Reader’s Question category.
Alexander Hernandez
Colleges and universities can purchase my bankruptcy law textbook directly from Routledge Publishing. For paralegals and students buying single copies, you can do so via Amazon books. To access my YouTube channel, click this link.
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Please note the information on this site does not constitute legal advice and should be considered for informational purposes only.
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