Walking Away From an LLC's Debt: 6 Questions About What Remains

Does Not Dissolve Its Debts

In general, closing down an LLC or even having it file for Chapter 7 bankruptcy does not dissolve its debts (which will remain intact). An LLC is a separate legal entity, and its debts belong to the LLC. And the owners aren’t necessarily relieved of any or all personal responsibility for company obligations, either. Even when the above holds true, the “company debt” is often a different legal matter from personal guaranty debt, which is the debt an owner or LLC member personally guaranteed with their own assets and which will follow them. Corporate structures can shield investors and owners from liability - they are the “corporate veil” - but this protection is not absolute.

In Chapter 7 bankruptcy, an LLC’s property (if any) is sold to repay creditors. When the LLC petitions for Chapter 7 bankruptcy, an automatic stay freezes most debt collection efforts against the company. But the automatic stay doesn’t last forever. Your creditors can request that the court lift the stay on collections. However, if you’re able to get Chapter 11 protection instead, you could reorganize the business under a court-approved plan.

Personally Responsible for LLC Debts

Regardless of whether you simply close up shop or have an LLC file for Chapter 7 bankruptcy, you’re still responsible for any debts you’ve personally guaranteed to LLC creditors. In fact, that’s the point of a personal guarantee. It puts your financial future as the guarantor on the hook if the LLC doesn’t pay what it owes on the loan.

If your company received a COVID-19 Economic Injury Disaster Loan (EIDL) from the Small Business Administration and defaulted on the loan, it isn’t automatically canceled when you close the business. Furthermore, depending on the amount you borrowed, you may have signed a personal guarantee that puts your personal property in jeopardy. The loans aren’t grants. For loans over $25,000, you had to pledge collateral. If it’s more than $200,000, you had to give a personal guarantee, too. Federal agencies can refer debts to the U.S. Treasury Department’s Bureau of the Fiscal Service for collection (known as cross-servicing). After a debt is 120 days past due, an agency generally must transfer the debt to cross-servicing.

In most cases, you won’t be on hook for business debts you didn’t personally guarantee. But, in rare cases, a court could decide that you’re personally responsible for LLC debts. This is the result of what’s known as “piercing the corporate veil” in a lawsuit. Courts are reluctant to pierce the veil to hold owners personally liable for LLC debts. The tests vary from state to state. But if you commingle personal and business finances, a court could potentially decide your LLC doesn’t have a separate identity, making its debts and liabilities your debts and liabilities. This can happen with undercapitalization - when the company lacks sufficient cash to carry out basic LLC functions and legal obligations to other parties. Another justification to pierce the veil is if the LLC was formed fraudulently.

Debts you owe on taxes you withheld from employees, called “trust fund taxes,” can also follow you. An LLC member may be personally liable for the trust fund taxes for the wages paid to employees. If your business doesn’t pay withheld income taxes or withheld FICA taxes, the IRS might ask you to personally pay these funds through a Trust Fund Recovery Penalty. This penalty equals 100% of the unpaid withheld income tax, plus the employees’ share of FICA. A business need not be out of business before the penalty is assessed.

Someone with the duty and the power to pay the taxes is a “responsible person” under tax law. If that includes you and you willfully failed to pay, you can be personally liable. That person can also be an LLC manager, a member or anyone else who has control over the finances. They’ll be on hook even without evil intent to defraud.

As an owner who’s about to cease operations, you might be tempted to take money out of the LLC to recoup what’s been sunk into it. You can’t prefer yourself over creditors without consequences. Under Delaware law, LLC members who knowingly accept a distribution that drains funds from creditors when the LLC winds up operations and goes out of business must pay back the distribution. Generally, it’s for a period of 3 years after the distribution. Some states have similar rules, while others don’t.

Business Shutdown

An LLC doesn’t close up just because you file for bankruptcy (Chapters 7 and 11 are the ones most used by businesses). Check your LLC’s operating agreement, which might say what you must do to disband the LLC. State law is relevant to what’s needed. If you file for bankruptcy, the court may control LLC assets while you’re in bankruptcy. The IRS has a checklist of things to do when closing a business.

You may not have to pay the full balance of a debt if you reach an agreement with the creditor to settle the debt. After you’ve paid a settled amount, the creditor might agree not to pursue you for the unpaid balance. Generally, debt forgiveness is considered taxable income, even in business debt scenarios. If $600 or more of your debt is canceled, your creditor usually sends you a Form 1099-C, Cancellation of Debt. But canceled debt can be considered taxable income even if you don’t receive the form. You can claim an exclusion if the debt is canceled in a bankruptcy proceeding or you’re insolvent. You can use Form 982 to do this.

How your business shutdown or bankruptcy affects your credit depends on several things. When your company files for bankruptcy, the bankruptcy can show up on the company’s credit report and hurt its business credit scores. It’s smart to review your credit reports after your company declares bankruptcy. Your reports may contain errors that could hurt your credit score. Always dispute any errors you find with the relevant credit bureau.

Before you have your LLC file for bankruptcy or simply walk away without filing, be very clear on which LLC debts you have personally guaranteed and which will go with the LLC (even in a bankruptcy). Gather the loan and collateral documents that show this. Meet with a bankruptcy attorney to review those documents.