Sole Proprietor Business Debt Relief: 5 Personal Exposure Questions

Sole Proprietors Are Generally Held Personally Liable

As the owner of your business, you are liable for the debts and obligations you take on in your business’s name. This is especially true if you are a sole proprietor. A sole proprietorship is a business structure with only one business owner. Unlike a corporation or limited liability company (LLC), the owner of a sole proprietorship isn’t the “owner” of a business. You are the business. If your business has debt, you have debt. In short, sole proprietors are generally held personally liable for any debts or lawsuits incurred by the business. So any plan to get out of debt has to start from a reckoning of what’s yours. The first questions to ask are five: how much do you owe; what have you guaranteed or put up as collateral; what do your creditors have the power to reach; how much will it cost to settle; and lastly, what is bankruptcy like.

The debt obligations of a sole proprietorship are entirely your own. That means vendor credit, business credit cards, equipment financing, and any loans, even under a trade name: that’s the owner’s obligation, and the business taxes are the owner’s responsibility too, reported on the Schedule C alongside your personal Form 1040. In other words, a sole proprietor can’t use the business structure as a shield against liability. When a sole proprietor quits and closes the business, business debts, lease obligations, and loan balances don’t disappear. The creditor can pursue the owner for these debts.

Even though the sole proprietor is personally responsible for the business’s debts, it does matter who the guarantor is: you might, for instance, be a co-guarantor. And note that some loans, including Small Business Administration (SBA) loans, still require an unlimited personal guaranty from anyone who owns 20% or more of a business. In addition, any assets you personally pledge (like your home or vehicle) give the secured creditor a right to repossess or foreclose on those assets to collect unpaid debt. If you do have other guarantors or cosigners, settling your own liability isn’t always the end of it. The creditor may still be able to pursue the collateral or collect the remaining balance from the other people who guaranteed the loan. That’s why it’s important to look at each individual contract.

Personal Bankruptcy

If you’re struggling with debt, at some point a creditor can bring a lawsuit against you, and if a judgment is obtained, or even threatened, your wages, bank accounts, home and other personal assets may be at risk. That’s a lot of pressure to land on top of the household finances. Your filing of a bankruptcy generally stops many collection actions against you, at least temporarily. The moment you file, it activates a provision in the bankruptcy code called the automatic stay. It may not protect a co-guarantor or co-owner.

Settling instead has its own cost: when debt is settled, forgiven, or canceled, in general you’re responsible for paying taxes on the amount the creditor canceled, because that’s considered a form of income. When a bank or lender cancels or forgives debt of $600 or more, they must file a Form 1099-C. The 1099-C reports the canceled amount for the year the cancellation actually happened. You do need to plan for this, so you’re ready for the amount of tax you might owe. The exception is if you’re insolvent or bankrupt, which allows you to exclude the canceled debt using Form 982, subject to certain rules. The insolvency exclusion only goes up to the amount you were insolvent.

Don’t assume tax debt can’t be settled, because even the IRS will negotiate through an offer in compromise. There’s a $205 application fee, although that’s waived for low-income applicants. If you hire help with other debts, the Consumer Financial Protection Bureau (CFPB) has some good advice: if a debt settlement company takes an upfront fee before settling any of your debts, that’s a red flag.

If you do file, it’s an unpleasant fact that personal bankruptcy can include sole proprietorship business debts in the total, even if they’re under a trade name. Chapter 7 can wipe out that debt, but only for individuals. A trustee will sell your non-exempt assets, and that includes property your business owns, so think through the consequences to both you and your customers. There is an exclusion in the federal exemption rules, though: it protects up to $3,175 in professional or trade tools you use for work.

Filing Chapter 13 is an option if you’re self-employed, but not always a first step. There’s a limit: your unsecured debt can’t be more than $526,700, and your secured debt can’t be more than $1,580,125. Either way, you’ll need to get credit counseling within the 180 days before you file.

List Every Debt

Before you get overwhelmed by the whole, divide it into parts. List every debt: who signed for it? Did you give a personal guarantee? Any collateral? Is the creditor threatening a lawsuit, or did they get a judgment already? If you’re behind on vendor credit, how much of it is for supplies and services you need in order to keep operating?

Don’t run to settle with the first creditor that applies the most pressure. Payment is in your favor if it’s keeping collateral, or if it’s keeping your business open: if the creditor can’t force payment and is only trying to pressure you into it, that extra payment might not improve your position at all. Negotiating an extension or workout, or even an orderly closure, might be the best option. When a creditor calls you demanding payment, don’t make a panicked commitment you can’t keep.