By Barbara Weltman: When your company needs financing, it may be difficult or impossible to obtain it unless you give your personal guarantee. This means if the company fails to pay its debt, you’re on the hook. Obligations for which you may be asked for your unsecured promise to pay if the company doesn’t are not limited to bank loans and lines of credit; they include commercial leases, car loans or leases, equipment leases and other financing arrangements. Make sure you fully understand what you’re getting into before you sign on the dotted line.
Forget personal liability protection
You incorporated your business or formed a limited liability company (LLC) with the understanding that you’d have personal liability protection. When you guarantee your company’s debt to a third party, you lose personal liability protection to the extent of the obligation you’re agreeing to pay if the company doesn’t (e.g., the company goes under and vacates the space). Thus, if your LLC takes a five-year lease on office space and the landlord requires you to personally guarantee the rent, your personal assets—your home, your car, and your bank account—are potentially exposed to the extent of the rent that’s owed.
Of course, you may not have to pay all or some of the remaining rent, because the landlord usually is required to seek a new tenant as quickly as possible. But you never know.
Know the type of guarantee you’re giving
There are two types of guarantees: a guarantee of collection and a guarantee of payment. Unless the loan agreement says otherwise, a guarantee is one of payment. This means that once there’s a default, the lender can seek payment from the guarantor (the person who gives his or her guarantee); the lender does not need to exhaust collection activities against the company that took the loan. On the other hand, if specific language in the loan agreement has a guarantee of collection, the guarantor must pay only after the lender has pursued legal action against the debtor (the company) and has obtained a judgment for the outstanding balance that has been unsatisfied or the debtor is insolvent (seeking a judgment in this case would be a worthless endeavor).
Most guarantees (e.g., for bank loans) are of payment and there may be little that you can do to change this arrangement. However, in some cases (e.g., for commercial leases), you may be able to negotiate for a guarantee of collection. Don’t assume.
Understand how a guarantee affects your S corporation basis
S corporation owners can deduct their share of business losses that are passed through to them only to the extent of their basis in the corporation—stock and debt. Debt for this purpose includes loans that an owner makes to the corporation; merely guaranteeing a corporate debt to an outsider doesn’t count because there’s no economic outlay for this promise. However, if you give a guarantee and are called upon to make good your guarantee, then you count the payments you make as debt that’s included in your basis. If you are an S corporation shareholder and the company is having a bad year, make sure you have sufficient basis to deduct the loss on your personal return.
Don’t ignore the impact on your credit rating
If you give a guarantee for company debt, such as a business credit card, your failure to pay if the company can’t will adversely impact your personal credit rating. In most cases, small business owners are required to provide personal information when their companies apply for a credit card. And, in some cases, if the company fails to make required payments, this action can show up on the owner’s personal credit report.
Check whether providing your personal information on a company’s credit card application makes you jointly and severally liable for the debt. This means you are just as liable for the balance as the company; the credit card issuer can come after you without exhausting collection activities against the company.
Check whether you can escape your promise
Your personal guarantee survives most events, such as selling your interest in the company. However, you may be able to be released from your personal guarantee by asking the lender to do so (e.g., you may be able to substitute a personal guarantee by the new owner). Alternatively, try to have the company satisfy the outstanding obligation before you sell your interest so there’s no longer anything that you still personally guarantee for the company.
Conclusion
Giving a personal guarantee is just a fact of life for many small business owners. But knowing what you’re undertaking can be helpful. And it may be possible to negotiate better arrangements that limit or even eliminate your personal exposure. Before you agree to anything, make sure you fully understand what your guarantee means and what you can do to protect yourself by consulting with an attorney.
About the Author:
Barbara is an attorney, prolific author with such titles as J.K. Lasser’s Small Business Taxes, J.K. Lasser’s Guide to Self-Employment, and Smooth Failing as well as a trusted professional advocate for small businesses and entrepreneurs. She is also the publisher of Idea of the Day® and monthly e-newsletter Big Ideas for Small Business® and host of Build Your Business Radio. She has been included in the List of 100 Small Business Influencers for three years in a row. Follow her on Twitter: @BarbaraWeltman.
This article originally appeared on the Small Business Administration’s SBA Blog.