If you run a small business and that business runs into financial difficulties, can your creditors force you to sell personal assets to repay money owing? Will unpaid business debt affect your personal credit as well as your business credit?
The answer to these questions largely depends on whether or not you are personally liable for the debts incurred by your business. If you’re not personally liable, creditors can only seek settlement from your business bank account or through the forced sale of business assets. However, if you are personally liable for your business debt, you could stand to lose your personal assets if there isn’t enough left in the business to repay creditors.
So how do you know if you’re personally liable or not?
This will depend on how you have structured your business status as well as any business agreements or contracts you have entered into.
Let’s take a look at some of the differences…
How Business Structure Affects Personal Liability
Many people choose to register their small business as a sole trader as it cuts down on paperwork and keeps things simple. However, as a sole trader, there is no legal distinction between you and your business. This means that you are personally liable for any money owed by your business and unpaid creditors may be able to force the sale of personal assets to recover their losses. The same is generally true of businesses registered as partnerships and here the consequences can be even worse because every partner is personally liable for the total debts of the business, not just their share. This means that if your partners don’t have money or assets, you could be forced to cover their share of the debt as well as your own.
If you’ve registered your business as a corporation or a Limited Liability Partnership (LLP), you and your business are separate in the eyes of the law. In theory, this means that you are not personally liable for your company’s debts.
In practice, however, most small business owners – whether they are majority shareholders or Limited Company Directors – find themselves personally liable for at least a part of their business debt. Here are the main reasons why.
Personally Guaranteeing Your Business
Following the 2008 financial crash, business lending by banks and other financial institutions has become increasingly restrictive as lenders seek to avoid any risk of bad debt. Even when lenders are willing to extend credit to a business, they normally require the borrower to sign a personal guarantee before the release of any funds. This guarantee means that the borrower voluntarily waives their limited liability. As such, the lender can sue to recover unpaid debts from the borrower’s personal assets.
While small business owners have much to lose by personally guaranteeing business debt, they have little choice if they want to access credit for their business. This is true not only for bank loans but also for commercial leases, credit from suppliers or loans to buy business equipment. Whenever you sign a business contract with a bank, leasing company, supplier or other creditor, you should check to see if a personal guarantee is included as part of the contract.
When you take out a bank loan for your Small Corporation or Limited Company, you will likely be required to put up your house or real estate as a form of security. As a result, if your business goes bankrupt, you could be sued by the lender and forced to sell the property in order to repay your business debt.
In addition, if you have used credit cards to access extra finance for your business, you will almost certainly be personally liable for those debts, even if the credit card has your business name on them.
Keeping Your Business and Personal Finances Separate
Many business owners also end up becoming personally liable for their business debts simply because they fail to maintain a formal legal separation between their business and personal financial affairs. This might mean using a personal credit card or cheque book to pay a business bill, or simply failing to keep proper minutes of a meeting when important business decisions were reached.
If your creditors can successfully demonstrate that you did not follow the formalities required by law of corporations or limited companies, you are likely to be held personally liable for any outstanding business debt. You could also receive a hefty fine or even face prison time if deliberate fraud or misrepresentation can be proved.
How Outstanding Business Debt Affects Your Personal Credit
If you’re left with outstanding business debts for which you are personally liable, you’ll either want to pay those off in full or try to negotiate a settlement with your creditors. Any debts that are not paid in full are likely to be entered on your personal credit history as a default. If your business debt is included in your personal debt, you will find it harder to qualify for personal credit and other forms of financing in the future. This may make it difficult for you to obtain a mortgage or acquire a loan to start a new business.
Another point to remember is that having a lot of debt – including business debt – in comparison to your personal income can negatively affect your credit score, even if you make repayments on time. It may even be that your business income is not calculated as personal income – regardless of whether you are personally liable for your business finances or not – depending on how your business is legally structured. In this instance, any business debt will weigh even more heavily on your personal credit.
It’s vital to understand your legal obligations before entering into any kind of business contract or agreement that can affect your personal credit, yet many business owners still misunderstand how their company finances can affect their personal finances.
If you wish to extend your personal credit in future, it’s likely that your lender will seek as much information as can be easily obtained, including data on past business loans. As such, it’s important to consider the long-term consequences of business debt, not only for your future business credit but also for your personal credit.
If you would like to talk further about this issue don’t hesitate to contact one of our expert business insolvency experts, or visit our advice for businesses page for more information.
Call 0161 907 4044 or submit our online enquiry form.