LLC Debt Liability

If your LLC is drowning in debt, you might be wondering how LLC debt liability works. You might even be considering filing for bankruptcy.

Navigating debt can be very stressful for any LLC. The good news: if you’ve run your business compliantly, you’re probably protected from personal liability for your business debts. Bankruptcy can offer you a fresh start or a second chance. And you might even have other options.

In this guide, we’ll cover all the essentials of LLC personal liability, LLC debts, and bankruptcy.

Types of LLC Debts

Debt as a business isn’t inherently a bad thing; many limited liability companies (LLCs) need to incur some debt to realize their full potential. There are lots of different types of business debts, including business lines of credit, term loans, mortgages, SBA loans, bank loans, and more. Every type of debt has a different repayment term, interest rate, and principal.

It’s not uncommon for an LLC to have to put up collateral for a loan, especially when the business is just starting out. Many business lenders are hesitant to offer loans without them until a business has proven itself. 

How LLC Bankruptcy Works

Sometimes, in the course of business, an LLC might realize that its debts and liabilities far overshadow its income. If there’s little chance of turning things around, the LLC might file for bankruptcy.

Bankruptcy is a dramatic, dreaded word for many business owners. But by filing for bankruptcy, many LLC owners can achieve a fresh start.

The Bankruptcy Process

If an LLC wishes to declare bankruptcy, its owner(s) will typically file a petition for bankruptcy — of the desired type — with the local bankruptcy court. This petition usually includes a schedule of the LLC’s income and expenses, its assets, and its debts and creditors. Then a case trustee (usually called a U.S. Trustee) is assigned to your case.

The case trustee administers the bankruptcy proceedings, either liquidating the business’s assets and distributing them or helping mediate a repayment or restructuring plan. Often, the process will require a meeting of creditors where the LLC’s members testify about the business’s financial situation.

Collections During Bankruptcy Proceedings

Filing a petition for relief puts your creditors on notice that you’re pursuing bankruptcy. Usually, creditors and collection agencies are not allowed to keep pursuing collections until the court makes its ruling. This bankruptcy protection gives relief from stressful collection calls. 

Types of Bankruptcy for LLCs

While U.S. Bankruptcy Code provides several different types of bankruptcy, not all of them are available to LLCs. There are two common types of business bankruptcy for LLCs: liquidation and reorganization.

Liquidation Bankruptcy

Liquidation bankruptcy is probably the type that most people think of when they hear the word “bankruptcy.” It’s also referred to as a “Chapter 7 Bankruptcy.” With this type of bankruptcy, the LLC surrenders ownership of all its business assets, and they’re liquidated by the appointed U.S. Trustee. Funds from liquidation help pay off as many debts as possible.

After liquidating, the LLC no longer has any means to continue business after bankruptcy, so it should dissolve, paying any outstanding taxes, canceling business licenses, and filing state paperwork. If the LLC doesn’t dissolve, it will still be subject to state minimum taxes and annual report fees. After dissolution, the members are free to pursue other ventures.

Reorganization Bankruptcy

Reorganization bankruptcy, or “Chapter 11 Bankruptcy,” works best for LLCs that need debt relief but don’t want to stop operating. Basically, the LLC retains possession of its business assets, but it makes a voluntary petition to create an amended repayment plan. Sometimes this entails paying creditors less than the contracted amount or expanding the period of time to repay one or more debts.

The Bankruptcy Code actually provides for two different types of reorganization bankruptcy for certain small businesses. Either way, taking a reorganization bankruptcy allows an LLC to stay in business. The catch: the creditors must approve the new repayment terms. Additionally, the bankruptcy trustee will closely monitor the LLC to ensure they’re keeping on track with repaying according to the amended terms.

How does declaring bankruptcy affect an LLC owner’s personal liability?

In most cases, declaring bankruptcy has no effect on the personal limited liability protections of the owners. The LLC is still a distinct legal entity from its owners, and LLC creditors cannot touch the members’ personal property.

That said, there are exceptions. If a member makes a personal guarantee or offers collateral for a loan, they can be held personally liable for that. A court can also rule to pierce the corporate veil, removing that personal asset protection (see below for more info).

Options for Managing LLC Debt

Debt isn’t always avoidable, but there are a few ways to manage the debt you have and avoid new debt. Here are a few tips:

• Keep accurate, up-to-date financial records. Knowing exactly where you stand financially day to day can help you make informed decisions. You might also be able to see a crisis coming and avoid it based on trends in your monthly income levels.
• Maintain a cash balance. Financial experts recommend having an emergency fund in place for your personal expenses, so why not have one for your business? Keeping a set amount of cash on hand in your account can rescue you in a pinch.

• Utilize a business plan. A well-written business plan can help add some structure and forethought to your business decisions. It might also help you avoid impulse purchases (or poorly timed ones).
• Reduce unnecessary business expenses. While you can’t avoid having business expenses, it’s good to regularly evaluate the ones you have. If you can eliminate or reduce some of your bills for unnecessary things, you can positively affect your bottom line. 

None of these steps will guarantee you won’t fall short of a debt, but they can certainly help you manage your financial affairs.

Look into out-of-court settlement options

In some circumstances, you may‌ be able to work out a mutually beneficial arrangement with a creditor by settling outside the courtroom. Of course, you’ll need to enlist the help of a business attorney. They’ll help draw up terms for settling your outstanding debt. This can also apply if someone has cause to file a lawsuit against your LLC.

The settlement option can actually save a debtor LLC time and money because a bankruptcy filing costs money and takes months to finalize. Your creditors may also prefer the option of settling because they often end up with more cash in their pockets, too. Granted, not all creditors may agree to a settlement. But it’s an option you can pursue.

Protecting Personal Assets

In most cases of bankruptcy, the LLC’s members have personal asset protection; their belongings can’t be seized to pay business debts. But all that changes if a court rules to pierce the LLC’s corporate veil.

“Piercing the corporate veil” is a term used to describe the circumstance when a court says that business owners can be held personally liable for business debts. This doesn’t happen often — typically when the owners abuse legal requirements in some way. Here are the primary reasons a court might pierce a corporate veil:

• The LLC committed fraud.
• The LLC’s members did not treat the business like a separate legal entity.
• LLC members didn’t keep their business finances separate from personal finances.
• The LLC started out undercapitalized.

Every state has slightly different criteria for piercing a veil, but those are the general causes.

How to Protect Your Personal Assets

To keep your personal assets protected, you must run a compliant business. Keep your business bank account separate, stay aboveboard with your business practices, and follow all legal formalities required in your state. If you do that, creditors will have a very hard — if not impossible — time coming after your personal assets.

Additionally, avoid putting a personal guarantee on a business loan as much as you can. You won’t always have this luxury, though, especially if you’re a small business. When you have to personally guarantee a debt, only offer collateral that you wouldn’t mourn losing. Don’t use valuable assets like your home if you can help it.

We can help!

Running a business compliantly is your best defense to avoiding bankruptcy and protecting your personal assets. But if that sounds overwhelming, don’t worry — ZenBusiness has your back. Whether you need a registered agent, tools to manage your money, or worry-free compliance, we can help. Let us handle the red tape so you can focus on what matters: your business.

Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.