Theoretically, Limited Liability Companies are supposed to cut off liability for the company’s debts so that the owners are not personally liable.
Still, there are many instances where your LLC may not be able to protect you. It’s important to know what these factors are so you know how to protect yourself from the consequences of debt.
One of the most appealing aspects of registering your company as an LLC rather than operating as a sole proprietorship is that the LLC is a separate entity. Creditors can only go after the LLC if debts are incurred in its name, but you may become personally liable if you acted fraudulently.
For example, if you provided false information on a loan application or if you intentionally overstated your company’s income and assets, or if you took a lot of money out of the LLC shortly after applying for a loan. In this case, the bank may chase you up for repayment of the loan.
Another instance where you may be personally liable for a loan is if you personally guarantee the debts of the LLC. This is common, particularly for new business owners taking out a loan.
This is because lenders may be cautious or refuse to give loans to the company alone because it doesn’t have a proven income stream. Giving a personal guarantee to a loan made by an LLC means if the LLC can’t pay the debts, then you will need to.
Yet another instance where you may be personally liable for a loan taken out by an LLC is when you haven’t separated the finances of the company from your personal finances.
For example, if you’re the sole owner of the LLC and you use the same checking account for your personal and business expenses. If the worst should happen and your LLC fails, a court could ‘pierce the veil’ of limited liability and deem you responsible for the LLC’s debts.
Limited liability also doesn’t protect you if you’re the person who has committed wrongdoing, so you could be responsible for a judgment against the LLC.
For example, if your LLC is a delivery service and one of your employees gets into an accident you will not be personally liable for the victim’s injuries.
But if you were driving the truck, you also have personal liability, and if the LLC is unable to pay for the damages you will have to use your personal assets to satisfy the judgment.
But what about co-signing?
A co-signer for a business loan is someone who guarantees the loan will be paid if the borrower defaults on the loan. Any small business owner looking for a start-up loan should seek out co-signers and be prepared to provide their details to the lender if needed.
A co-signer is also known as a guarantor, and Small Business Administration (SBA) loan guarantees effectively act as a ‘co-signer on small business loans.
A lender will usually ask for a co-signer if it needs more information or to secure the loan and be assured the loan will be paid off.
Banks usually require a co-signer on business start-up loans for new businesses in particular, because the business will have no business credit history for the bank to rely on to pay back the loan.
It’s important to note the co-signer isn’t just a signature on a piece of paper, it’s a promise to repay the loan if the borrower defaults.
Co-signers are usually also asked to provide collateral such as property or other assets which the bank can sell to recover their money if the borrower defaults.
The co-signer will also need to provide a personal financial statement, and their credit rating will be checked and considered as part of the application process.
The co-signer’s credit rating must be good or they must have personal or business assets in the case of a business loan. They will also be required to pay fines, late charges, and penalties if the borrower fails to.
The co-signer also signs all loan documents, therefore agreeing that they will honor the terms of the loan. The bank will keep in contact with the co-signer and they will be notified if the applicant does not make payments on time.
But while being a co-signer is a big responsibility and not without its risks, it may be the only way for a business owner to access capital to start their business.
A co-signer may also be needed if the borrower has a poor credit score that could impact their business loan application, or does not have the personal assets to back their loan.
However, this may backfire if the business can’t generate the revenue needed to pay off the loan, or if it can’t meet time-sensitive requirements. If you are thinking of co-signing for a loan, make sure you and the other party have everything in writing.
If you are a business owner who is considering bringing on a co-signer, it does avoid you having to provide collateral or a personal guarantee. A co-signer also reduces the risk of the loan defaulting, and this is why lenders will ask for collateral in the first place.
A co-signer can also help you meet the lender’s collateral or personal guarantee requirements by offering their own assets as collateral.
It is worth noting that using a co-signer is a bit different when applying for a business loan than when applying for a personal loan.
This is because the lender tends to decide or recommend your application could benefit from a co-signer. So while it is worth considering a co-signer, ultimately the decision is not entirely up to you.
What complicates it a little is the fact that most lenders don’t advertise if they accept co-signers.
Sometimes a lender will recommend bringing on a co-signer after they have reviewed factors such as a business’s financials, credit ratings, the assets of the business owners, and any collateral.
How does an LLC affect a credit report?
So let’s say you have an LLC, and you have used it to take out a loan or co-sign a loan. You may be wondering how it will affect your credit score, and how it may appear on your credit report.
Businesses have credit reports too, and this helps lenders decide how much interest to charge and, indeed, if a business is creditworthy.
Your LLC will have a separate credit report to your personal credit history but in some circumstances, both credit reports will be affected by certain information.
If the LLC has debts that have only been taken out in the company’s name then only the LLC’s credit will be affected.
So if the bank gives a $20,00 loan to an LLC and nobody involved in the LLC cosigns or guarantees the loan, if the LLC then goes bankrupt only the credit of the LLC will be impacted. It will not appear on the credit reports of any of the members.
But if you personally guarantee a loan to the LLC, this will appear on your credit report too. As we have already mentioned, lenders will want the owner to be personally liable if the business is new in case things go wrong.
But if the loan gets paid off as agreed, this will have a positive impact on your credit score because a loan being paid off on time will improve your payment history.
Similarly, if the LLC can’t pay back the loan or if it makes late payments, this will appear on your credit report as well if you offer a personal guarantee.
It’s important to note too that larger loans can negatively affect your credit report even if the LLC pays the loan as agreed.
According to the Fair Isaac Corporation which developed a popular credit scoring algorithm, 30% of your score is made up of the amounts owed on your credit report.
If you have a $200,000 business loan that you personally guaranteed that may appear on your personal credit report because it is likely you are going to have to use personal assets to help pay off such a large sum.
This could lower your credit score and could affect any personal borrowing you wish to do.
But as we touched on earlier, your personal credit report is only affected if you cosign or guarantee an LLC loan.
If you don’t, then your credit report won’t be affected. If you own a few LLCs and you are interested in a bank loan, and the bank requests a cosigner and another owner of one of your LLC agrees but you don’t, then you’re not responsible.