What Happens to Debt When an LLC Fails?

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If an LLC fails, your personal assets should be safe if you ran the company as a separate entity.
If an LLC fails, your personal assets should be safe if you ran the company as a separate entity. (Image: Comstock/Stockbyte/Getty Images)

A Limited Liability Company protects business owners from being personally liable for the company’s debts. The LLC label, however, doesn’t ward off creditors from your personal assets by magic. If an LLC fails, and owners are not careful on how they secure loans, sign leases or spend the LLC’s money, they can be held personally liable if the company fails and must dissolve.

Pay Creditors First

Unlike a sole proprietorship or general partnership, an LLC designates the company as a separate legal entity from its owners. When an LLC is forced to dissolve, it must notify creditors to present any outstanding claims against the company. The time they have depends on state regulations. If the owners established and managed the LLC properly, only the company’s assets are available to pay off the debts.

Honor Personal Guarantees

If an LLC member, as partners in an LLC are called, chooses to sign a personal guarantee to secure startup funding, that guarantee is still in force if the company fails. In that instance, the member is only liable for the amount of the guarantee, but would not be liable for other debts incurred by the company itself.

Negotiate With Creditors

The members of an LLC can vote to dissolve the company at any time, but they must follow procedures as set by the state. If the company has enough assets, it first pays off all creditors. Once creditors are paid, any remaining assets can be divided among the members, each receiving a percentage of the assets equalling their percentage ownership in the company. If the company cannot pay off its entire debt, it can negotiate with creditors or file for bankruptcy and let the courts decide.

Avoid Surprise Personal Liability

While a personal guarantee for startup funding may be a reasonable choice to make, vendors who are still owed money could go after member’s personal assets over practices that may go unnoticed until the company dissolves. Then it’s too late to avoid losing liability protection. LLC members should review any leases, contracts and service agreements carefully before signing to be certain the documents don’t include language that makes individual members a party to the agreement. An agreement may include “standard language” that attaches personal assets if the company itself is not able to pay. Negotiate to remove the language before signing, or at least limit any personal liability. If not, members could face surprising and overwhelming personal debt when the LLC closes.

Manage LLC Funds Separately

An LLC is a separate legal entity as long as members treat it that way. If creditors decide to take an LLC to court to recover outstanding debts, a judge will examine company records to be sure its members didn’t use LLC business accounts for personal use. If a judge finds members have dipped into business funds for non-business affairs, he can rule the LLC never existed in practice. As with a partnership or sole proprietorship, the members would be liable for all the company’s debts. If the members have maintained the LLC as a separate legal entity, creditors may have to accept less than full payment for the amount owed.

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