The Double Whammy of Bankruptcies
This article was written by Simona Covel of the Wall Street Journal.
Entrepreneurs often don’t realize that their personal assets are at risk. Until it’s too late.
Bankruptcy is an ordeal for executives at any business. But for entrepreneurs, it’s often a double whammy: Their personal possessions are in jeopardy along with the business assets.
As thousands of business owners are discovering during this downturn, sole proprietors are nearly always forced to file for personal bankruptcy if business debts overwhelm them. As far as a court is concerned, the person and the business are one and the same. Even owners of limited-liability corporations or corporate partnerships are often held hostage by loan agreements that use their personal assets as guarantees.
Their experiences hold a hard lesson for entrepreneurs trying to protect themselves during tough economic times: Before you start a business, understand exactly what risks you face if you run into trouble. Many small-business owners in bankruptcy simply didn’t realize that creditors could take their possessions if the business failed.
On the Hook
In a sole proprietorship, “you can’t say, ‘I’m just filing [bankruptcy] for the business,’ ” says Lesley Hoenig, an attorney in Mount Pleasant, Mich. “There’s no business to file, because it’s not incorporated.”
Susan Hartzler is beginning a personal bankruptcy filing as the revenue from her solo business slips
Consider Susan Hartzler, who started a public-relations firm, Alpha Dog PR, in 2006. She’d had trouble with business partners in the past, so she decided to operate as a sole proprietorship with some part-time help. The expense of forming a corporation—such as accountants and lawyers—seemed unnecessary, since she planned to keep the company small.
In its first year, Alpha Dog PR collected about $30,000 per month. But as the recession’s grip tightened, business began to slip. Some customers stopped paying. Others disappeared altogether. Today, the Los Angeles-based business brings in about $4,000 per month, and Ms. Hartzler can no longer hold off creditors. She’s beginning a personal-bankruptcy filing, even as she scrambles to drum up new products to revive her business.
She had no idea she’d have to go that route. “I didn’t know that personal assets would be on the hook,” Ms. Hartzler says. When she talked to advisers about setting up a company, “I didn’t know to ask,” she says.
In recent months, tens of thousands of business owners like Ms. Hartzler have struggled to hold on to homes and cars as their businesses crumbled. Total U.S. bankruptcy filings rose 36% to 711,550 during the first half of this year, compared with 522,205 cases filed over the same period in 2008, according to the American Bankruptcy Institute in Alexandria Va. Business filings jumped 64%, while personal filings—which would include many sole proprietors who file as individuals—rose 35%.
The rise in bankruptcies comes on the heels of several years of expansion in sole proprietorships, as a booming economy convinced people the time was right to strike out on their own. According to data from the U.S. Census Bureau, the number of companies without employees grew to nearly 22 million in 2007, a steady climb from fewer than 18 million in 2002.
Not Enough Cover
Sole proprietorships are particularly risky, but even LLC or corporate structures aren’t always as safe as many entrepreneurs assume. True, these arrangements can protect one partner in a business from another’s liabilities in the case of a bankruptcy. And both structures can protect a business owner from some claimants who could go after a sole proprietor.
But the structures do little good when an owner has signed a personal guarantee for a loan. And these days, banks are forcing many business owners to provide those guarantees—often in the form of their homes, cars or other personal assets—in order to secure debt financing.
“That’s the rub,” says Jeff Kucera, a partner at law firm K&L Gates LLP in Miami. When small businesses seek debt financing, “they largely have to sign a personal guarantee.…Most guarantees are very, very broad and seek as much relief as possible.”
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