Taking out loans for business operations is sometimes unavoidable. Business loans are typically taken out for the following purposes:
- To buy real estate
- To lease office or retail space
- To lease or purchase expensive equipment
- To purchase items on terms
In dire financial crisis, businesses may take out loans to cover their overhead expenses. These loans have to be paid back within the stipulated amount of time, and at the rates agreed upon. However, sometimes businesses fail, leaving the owners with the responsibility of making good on the loan. Whether or not you are liable for the debt that your business incurs depends on the business structure, and any agreements that you may have signed with the financial institution.
Types of Business Ownership
Depending on the structure of your business, you may end up assuming the liabilities of the business or you may be protected from them. Some business structures are created with the purpose of protecting its owners from personal liability in case the business falls on hard times.
- Sole Proprietorship
This is the most basic type of business and the easiest to establish since there are no state registration requirements. The individual only needs a business name, location, and a business license to start operating. This business has only one owner, and no legal separation between the owner and the business. This type of business is advantageous because you are able to use the losses the business incurs to offset any personal income when filing your tax returns. You only pay taxes once, and you are in total control of the business operations.
However, since there is no separation between you and the business, you become personally liable for any debt that the business incurs. Your personal assets can be used to pay off the liabilities of the business, and you cannot file for business bankruptcy without filing for personal bankruptcy.
A partnership business involves two or more persons who come together to carry on a business as co-owners. The partners pool money to contribute their skills and share in the profits and losses of the company. The business has to be registered in the state it is located in, and partners have to adhere to the specific partnership laws stipulated in that particular state.
Depending on the type of partnership, the partners may or may not be personally liable for the debt incurred by the business.
- General Partnership
In this partnership, the individuals agree to share in the profit, assets, financial, and legal liabilities of the business. The partners have unlimited liability, which means that their personal assets may be used to offset any liabilities of the business. Unlimited liability also means that any particular partner may be sued for the entirety of the partnership’s liabilities. The potential liability that a partner faces is not capped, and his personal assets may be seized to pay off the entire partnership’s debt.
- Limited Partnership
Limited partnership businesses have at least one general partner and at least one limited liability partner. The general partner is in charge of the day-to-day operations of the business, and is personally liable for the partnership’s debt. The limited liability partner, also known as a silent partner, cannot be held liable for the partnership’s debt. The debt collector may use the personal property of the general partner to offset the business’ debt, but cannot use that of the liability partner.
- Limited Liability Partnership
A limited liability partnership is designed to protect the partners from the liabilities of the business. However, laws governing limited liability partnerships vary from state to state. In some states, the LLP is required to have at least one general partner. In certain states, the liability protection only covers negligence claims. In these states, the partners are still liable for any debt that arises from contracts. This may include credit card debt and any realistic loans taken out by the business.
A corporation is a legal entity that enjoys some of the same rights and responsibilities that people do. The corporation can sue and be sued, loan and borrow money, own assets, enter contracts, and pay taxes. Corporations are owned by individuals who own a percentage of the company, known as shareholders. Shareholders enjoy limited liability, and collectors cannot use the shareholders’ personal assets to pay off the liabilities of the corporation. However, shareholders owe a duty of care to the corporation and may be found personally liable for the corporation’s debt if they neglect this duty.
Shareholders may be found personally liable if the creditor manages to pierce the corporate veil. This means that the creditor is able to prove that corporate formalities were not followed, the shareholders mixed personal and business finances, or that the corporation was created as a shell company to protect the owner(s) from personal liability.
- Limited Liability Company
Limited liability companies resemble corporations in that the members (owners) are shielded from the liabilities of the company. The owners cannot be held personally liable for the company’s debt. Similar to a partnership, an LLC does not file taxes directly. The profits and losses of the LLC are listed in the owners’ personal tax returns. The company’s losses can be used to offset an owner’s income, but only up to the amount invested. However, a creditor may be able to hold the owners personally liable for the company’s debt by piercing the corporate veil.
When you Sign a Personal Guarantee
A personal guarantee is a legal agreement between an executive or owner of a business and the financial institution that the business is obtaining a loan from. Personal guarantees allow the financial institution to provide better rates since the guarantee acts as extra protection. However, when you sign a personal guarantee, you give the creditor rights to all your personal assets if the business defaults on the loan. The creditor may use your checking accounts, savings accounts, real estate, and/or cars to redeem the amount owed. Ensure that you do a thorough research into the earning potential of the business before you guarantee a loan.