Small Business Owners and Personal Bankruptcy in Pennsylvania: Sole Proprietors, LLC Owners and Personal Guarantees

Short answer: Personal bankruptcy can address business-related debts that you owe personally, including most personal guarantees, but it works differently depending on whether you are a sole proprietor, a member of an LLC, or both. An individual with regular income, including a self-employed one, may be eligible for Chapter 13, while a business entity that is not an individual cannot receive a Chapter 7 discharge. Some business-related tax debts survive. An attorney can confirm how this applies to your case.

Sole proprietor, LLC owner, guarantor: who actually owes the debt?

The first question in a business-owner case is whose name is on each debt. Pennsylvania treats an LLC as a separate company. Under 15 Pa.C.S. § 8834(a), a debt, obligation or other liability of a limited liability company is solely the debt, obligation or other liability of the company, and a member or manager is not personally liable for it solely by reason of being or acting as a member or manager. That rule applies regardless of whether the company has one member or several.

Two points follow. First, a sole proprietor does not have that statutory separation, so business debts you incurred in your own name are your own debts. Second, the key words in § 8834(a) are “solely by reason of being or acting as a member.” If you signed a personal guarantee, co-signed a credit line, or are personally responsible for a particular tax, you owe that debt on a different basis. Sorting each debt into “company only” or “also mine” is usually the first job at a consultation. Our page on owner-operator bankruptcy walks through this for one industry; this page covers the general rules. For an overview of options, see small business bankruptcy in Pennsylvania; this page goes through the statutory rules.

Why a company cannot receive a Chapter 7 discharge

Under 11 U.S.C. § 727(a), the court shall grant the debtor a discharge unless one of the listed grounds applies. The first listed ground, § 727(a)(1), is that “the debtor is not an individual.” So a corporation or LLC does not receive a Chapter 7 discharge. When an LLC’s debts are the LLC’s alone, the company’s creditors generally look to the company, not to you. When you are personally liable, you file as an individual, and under § 727(b) a Chapter 7 discharge covers debts that arose before the date of the order for relief, subject to the exceptions in the Code.

Chapter 7 or Chapter 13 for a self-employed individual

Chapter 13 is limited to a person who meets § 109(e). The statute begins, “Only an individual with regular income that owes, on the date of the filing of the petition,” debts within the limits it then states. The limits are dollar figures that are adjusted over time, so this page does not state them; check the statute or ask an attorney for the current amounts. Under § 101(30), an individual with regular income is an individual whose income is sufficiently stable and regular to enable the individual to make payments under a Chapter 13 plan. Section 1304(a) describes a debtor that is self-employed and incurs trade credit in the production of income as engaged in business, and § 1304(b) provides that, unless the court orders otherwise, a debtor engaged in business may operate the business. So the Code expressly contemplates self-employed Chapter 13 debtors who keep operating. Because § 109(e) speaks of an individual, an LLC or corporation is not itself a Chapter 13 debtor.

Chapter 7 works differently. The trustee’s job under § 704(a)(1) is to collect and reduce to money the property of the estate, and the estate under § 541(a)(1) consists of all legal or equitable interests of the debtor in property as of the commencement of the case. For a sole proprietor, business equipment, inventory and receivables you own are your property and are part of that analysis, subject to exemptions. For an LLC member, the debtor’s interest in the LLC is what the debtor owns, which is different from the company’s own assets; how that interest is treated depends on the operating agreement and the facts. Compare the chapters at Chapter 13 vs. Chapter 7, review Chapter 13 eligibility and Chapter 13 debt limits, and see how exemptions may apply to tools and equipment. The means test under 11 U.S.C. § 707(b) applies only when an individual debtor’s debts are primarily consumer debts, and § 101(8) defines a consumer debt as one incurred by an individual primarily for a personal, family, or household purpose. The Code does not define “primarily” for this purpose. Courts have not applied a single test. The Ninth Circuit, for example, treats the threshold as met when more than half of the dollar amount owed is consumer debt (In re Kelly, 841 F.2d 908 (9th Cir. 1988)), and other courts also look at how many debts are consumer debts. Under either approach, an owner whose debts are largely business debts may fall outside the means-test presumption. Each debt is classified by the purpose for which it was incurred, so the line has to be worked out debt by debt, and an attorney can confirm how it applies to your case. When it does apply, the official means test form calculates business income as receipts less ordinary and necessary operating expenses, so the business figures need care.

Personal guarantees

A personal guarantee is your own promise to pay if the business does not. In bankruptcy it is generally an ordinary debt of yours, so it can be discharged along with other debts of that kind unless an exception applies. Exceptions in § 523(a) include debts for money obtained by false pretenses, a false representation, or actual fraud (§ 523(a)(2)(A)) and for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny (§ 523(a)(4)). A guarantee given in the ordinary course of business is not one of these categories merely because it is a guarantee, but how a loan application was completed can matter. If the guarantee is secured by your home or other property, the lien is a separate issue. A discharge ends personal liability but does not necessarily remove a lien (see the discussion of Dewsnup v. Timm in our post on judgment liens). In Chapter 13, § 1328(a) grants a discharge of debts provided for by the plan, again with exceptions.

Trust-fund taxes and other tax debt

Under 26 U.S.C. § 6672(a), a person required to collect, truthfully account for, and pay over a federal tax who willfully fails to do so is liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over. In plain terms, withheld payroll tax can become a personal problem for a business owner who was responsible for paying it over and willfully failed to, even if the business was an LLC.

The Bankruptcy Code points the other way on discharge. Section 523(a)(1)(A) excepts from an individual’s discharge a tax of the kind and for the periods specified in § 507(a)(3) or 507(a)(8), and § 507(a)(8)(C) covers “a tax required to be collected or withheld and for which the debtor is liable in whatever capacity.” Section 523(a)(1)(B) and (C) separately reach taxes where a required return was not filed or was filed late, or where there was a fraudulent return or willful evasion. Section 1328(a)(2) carries the § 507(a)(8)(C) category and the § 523(a)(1)(B) and (C) categories into the Chapter 13 discharge exceptions. The practical point is that tax debt is the category most likely to survive, so it needs to be reviewed first. See nondischargeable debts for the broader list.

Common fears and misconceptions

• “My LLC protects me from everything.” Section 8834(a) protects against liability that exists solely because you are a member or manager. It does not cancel a guarantee you signed.
• “Filing personally closes the business.” Not by itself. Section 1304(b) lets a Chapter 13 debtor engaged in business continue to operate unless the court orders otherwise. A Chapter 7 may affect business assets you own personally.
• “The LLC can file and get a fresh start.” Under § 727(a)(1) an entity that is not an individual does not receive a Chapter 7 discharge.
• “All of the business debt is erased.” Some categories, especially certain taxes, are excepted.

Mistakes to avoid before filing

• Paying some personal-guarantee creditors, relatives, or yourself out of business accounts right before filing without legal advice.
• Using personal funds to pay trust-fund taxes selectively without checking the consequences.
• Mixing personal and business accounts, which makes the schedules harder to prepare accurately.
• Waiting until a creditor has already obtained a judgment; see wage garnishment in Pennsylvania.
• Assuming a larger business restructuring is a personal-bankruptcy question. The Code has a separate Chapter 11 pathway for small business debtors, discussed below.

A pointer on Subchapter V

This page is about personal filings. Subchapter V of Chapter 11 is a separate structure for qualifying small business debtors; § 1182(1) defines its debtor as a small business debtor. Eligibility turns on that definition and its limits, which this page does not cover. If the business itself is what needs restructuring, ask an attorney whether that route fits.

What to expect at a consultation

Bring a list of every business debt and who signed for it, copies of any guarantees, recent tax returns, any IRS or Pennsylvania Department of Revenue notices, the LLC’s formation and operating documents, and recent business bank and credit card statements. An attorney will typically sort debts into personal and company-only, identify tax exposure, and compare Chapter 7 and Chapter 13 for your situation. We serve business owners in Dauphin County and Cumberland County.

Call (717) 724-7503 or schedule a consultation to talk through your situation.

We are a debt relief agency. We help people file for bankruptcy relief under the Bankruptcy Code.

Sean P. Quinlan, Esq., Quinlan Law Group, Camp Hill and Harrisburg, Pennsylvania.

This page is general information about Pennsylvania and federal bankruptcy law, not legal advice for your situation, and reading it does not create an attorney-client relationship. This is attorney advertising. Deadlines and outcomes depend on your facts; talk to a licensed attorney before relying on anything here.