When a Business Folds, Who Is Responsible for Its Debts and Other Obligations?
Provided by HG.org
A common question among small business owners is who will be responsible for debts and other obligations if a business entity folds or reorganizes. Many things can happen in the life of a business entity, whether a corporation, LLC, partnership, or sole proprietorship, and this can lead to questions about who will be left holding the bag.
For example, if two partners own a company together and the company has a lease, what will happen to that lease obligation should a change occur to the business entity? It all depends on the type of entity, the terms of the lease, and how the parties created their agreement. First, if the business entity is a corporation or LLC, then the individual owners will probably be shielded from all liability under normal circumstances. That is, unless the owners provided a personal guarantee on the lease. In that case, both the business entity and the owners would be liable under the terms of the lease. Notably, partnerships and sole proprietorships usually do not afford that sort of insulation from liability, so it would be immaterial whether the owners signed personal obligations or not; they would usually be liable.
Let us imagine, on the other hand, that one of the owners decides they want out and moves to dissolve the business entity, while the other wishes to continue on with the business in the same location under the same lease as though nothing had changed. Can the other owner stay in the leased property, or will she have to start an entirely new lease, possibly in a new location? Again, there are a number of other factors that will go into this analysis. Can one owner buy out the other partner's interest in the company in order to maintain its corporate existence? If so, that will be the only transaction needed to maintain the status quo in all other respects. If not, will the landlord allow a substitution of the other partner's new company or sole proprietorship into the place of the dissolving company? At worst, the landlord may refuse to allow any but the entity on the lease to retain possession, and that could render the landlord a creditor from the dissolved corporation's assets. If the owners signed personal guarantees, the landlord would have a difficult time removing the owner/guarantor from the property, even if not still operating under the same corporate name, provided rent and other obligations are timely paid. The same would probably hold true if the business entity was a partnership.
But, what about other obligations? As noted, one of the biggest benefits of a corporation or LLC is that it shields its owners from direct liability. So, while a partnership or a sole proprietor that folds would expose its owners to personal liability for any remaining obligations of the business after it closes, a corporation or LLC's liability would be limited to the assets owned by the business at the time of its dissolution. This could include both bank accounts and other financial assets as well as personal or real property. Often, smaller businesses mingle personal and business assets without realizing that this could potentially expose them to liability. On the one hand, items bought by the company but used in a personal manner (e.g., computers, vehicles, etc.) may still be considered assets of the business at the time of its dissolution, and might be used to pay off creditors. This could leave the owners without their means of transportation or their laptop. On the other hand, this sort of mingling of assets could lead creditors to view the corporation or LLC as a vehicle by which the owners were attempting to defraud potential creditors. This could lead to what is known as “piercing the corporate veil,” or exposing the assets of the owners of a business entity to direct, personal liability for the company's obligations where the corporation or LLC was used as an alter-ego of the owner to defraud creditors.
If you are considering either creating or dissolving a corporation, your best option is to consult with a qualified, experienced attorney. A lawyer can help you create the best form of business entity to protect your personal assets, help you negotiate contracts that will allow you the greatest protection and flexibility in any circumstance your business may face, and help you navigate the tricky dilemmas that can arise from ending your business.
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.