Choice of legal entity can impact your biz during wind-down

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Most small businesses plan extensively for their launch and initial operations. Optimism and ambition are the common traits that motivate most entrepreneurs to take the proverbial plunge.

While admirable, this myopic approach does not consider the real prospect of financial adversity in the marketplace. Most business startups will face real −and usually healthy− financial challenges. Still others will fail and usually within three to five years of their launch date.

A business owner’s exposure during the winding-down phase of operations is highly dependent upon many factors, including the nature of the business concern. The first consideration will likely be the choice of legal entity.

Legal entities are nothing other than legal fictions created by our general assembly that give certain business forms the status to be treated as a “person.” The purpose of these entities is to encourage investment by limiting the risk associated with starting a new business.

That said, many businesses disregard entities entirely and operate simply as sole proprietorships— a decision that requires no filings with the Ohio Secretary of State. A sole proprietorship does not limit the business owner’s personal liability for debts and other obligations of the business. Conversely, a limited liability company (LLC) does generally protect its owner (member) from the business debts and liabilities. Though corporations operate differently, they too give protection to the owner (shareholder).

Nice as those legal protections may be, most business owners regularly waive them in their dealings with creditors. Unless a business has been established for quite some time (think AT&T or AEP) or has considerable resources to secure payment, business creditors usually insist that business debts be personally guaranteed by the members or shareholders to ensure payment. Technically speaking, any contract term is negotiable, but these provisions are usually insisted upon by creditors to ensure some form of recourse in the event of default.

Given the typical life span of new businesses, this request is not entirely unreasonable. Personal liability, of course, nullifies some of the most desirable benefits of the business entity, exposes the owner to collection lawsuits, and puts his or her personal assets at risk of collection proceedings.

An analysis of the nature and amount of all business debts should be done once a business owner decides to jettison the business. If all business debts are exclusively in the name of the business and not personally guaranteed by the owner −and the business will cease operations permanently− not much may need to be done in terms of a bankruptcy filing to discharge the outstanding indebtedness. In this instance, creditors of the business entity will only be left to pursue the entity for any and all outstanding obligations. (Note that some debts, including taxes, are treated differently and may, in limited instances, still obligate the business entity’s owner.)

The more common scenario, however, is that many of the business debts were personally guaranteed by the business owner. The failing business also may have been “subsidized” by personal credit lines of the business owner. In either event, the business owner has no protections from the collection remedies of his or her creditors and may be subject to lawsuit and collection proceedings.

It is in this instance that a personal bankruptcy filing may be of help to “sever” the personally guaranteed business debt from the owner.  Unless a business wishes to continue its operations, a business bankruptcy filing is generally not required. Moreover, a business bankruptcy filing will not discharge the business owner’s personal liability on the debt.

That said, bankruptcy is not the only way to resolve outstanding debt issues, but it is the only absolute remedy for individuals facing serious and insurmountable indebtedness when no other options are available.