Using Personal Funds To Finance A Business: Navigating The Complexities Of Bankruptcy And Liability

Using personal funds to finance a business is a common practice among business owners. However, when faced with unexpected challenges or business failure, personal liabilities can become a serious problem, putting both the business and the individual at risk. This article unpacks the:

• Consequences of using personal funds to finance a business.
• Complexities of bankruptcy.
• Difficult choices business owners face in navigating these financial hardships.

How Common Is It For Business Owners To Finance With Personal Funds?

Using personal funds to finance a business is fairly common for business owners. This is because, on the surface, it seems like an incredibly attractive option, and in some ways, it may be. For example, from a cash flow point of view, when the business and greater economy are doing well, things are great. Personal liability quickly becomes a massive burden when faced with these unexpected challenges and difficulties. In these situations, creditors have recourse to the business and the individual acting as its principal.

Principals who use personal funds to finance their business often do so until the business fails without ever taking a paycheck. This causes serious problems for them because doing so prohibits them from receiving unemployment after it fails. Had they taken a salary from the business, they would be entitled to collect unemployment.

Even worse is if the debtor files for Chapter 11 bankruptcy and has many assets and loan repayments. By co-mingling personal and business expenses, principals open themselves up to bankruptcy trustees and creditors going after their personal assets to the extent that they were given to the principal in fraud of the corporation’s creditors.

In the 1980s, I received a call from a couple who had recently launched an office equipment business. Initially, they were doing exceptionally well, as many businesses often do. However, they made an enormous oversight by failing to pay sales tax, which resulted in $100,000 of outstanding debt.

Desperate for a solution, the couple approached their family attorney, who represented them throughout the legal proceedings despite not having nearly the necessary experience to do so successfully. Instead of pursuing a Chapter 11 bankruptcy, which likely would have allowed the couple to repay their tax debt over five years, the attorney filed for Chapter 7, a liquidation, given that the tax debt was their sole financial obligation.

This decision had profound consequences. One of the questions posed in the bankruptcy filing pertained to whether any preferential payments had been made to an insider or creditor within the past year, particularly if the insider was the principal of the business. The attorney listed preferential payments of $96,000.

They had employed a resourceful accountant who suggested a creative approach: rather than withdrawing funds as salary and incurring taxes, they treated the amounts as loan repayments to the company. This action ultimately forced the couple into a Chapter 13 bankruptcy, requiring them to reimburse the trustee for the preferential payments, which, in turn, settled their outstanding tax liability. Once again, the mingling of their personal income and loan repayments triggered this chain of events.

Ironically, the case had a stroke of poetic justice: the couple unexpectedly received a $42,000 refund from the IRS, although issued erroneously. If the IRS does not claim such a refund within a specified period, recipients may keep what they were given and that is exactly what this couple did.

What Are The Risks Of Using Personal Funds To Finance My Business?

There are several reasons why using personal funds to finance your business can be problematic. Firstly, if the business fails, you may not have the cash flow necessary to meet minimum payments on your personal credit cards.

Obtaining loans for a corporation often requires personal guarantees. By guaranteeing a loan, the debt falls back on you if the corporation cannot repay them. Thus, many individuals find themselves in a situation where filing for bankruptcy becomes the only viable option. The burden of liabilities left behind when a business fails can become overwhelming and difficult to manage.

Do Business Owners Have A Choice?

So much of this issue ultimately boils down to a calculation. When I file bankruptcy for someone whose business has failed, I begin by listing all the business debts. This is necessary because there may be instances where the individual has personally guaranteed certain debts or creditors argue that they were personally liable.

We include a disclaimer for those debts, stating that they were incurred due to the failure of the business or the debtor’s personal guarantee. Alongside these business debts, individuals often have regular consumer debt, such as credit cards or loans used for personal expenses.

The calculations involve lumping together all consumer debt, including mortgages. Where the real problem arises is if the total amount of mortgages and credit card debt adds up to, let’s say, $750,000, while the business debt is only $500,000, it may complicate filing the case as a business bankruptcy.

If you do not have to factor the spouse’s income into the bankruptcy equation, it becomes much easier to file for Chapter 7 bankruptcy without complications. However, if you have to consider the household income as a whole, it may lead to a Chapter 13 filing or make it more challenging to meet the criteria for Chapter 7.

For more information on Using Personal Funds To Finance A Business, an initial consultation is your next best step. Get the information and legal answers you are seeking by calling (978) 922-8440 today.