How investing in a small business can put you at risk

A high number of personal insolvencies involve small business owners and contractors

Operating a small business requires a significant investment in terms of time, money and resources. And there can be implications for you personally, beyond just your business enterprise, if things begin to go south financially. Depending on the nature of the debts incurred, the legal structure of your company and how you manage your business debts, you may find your personal finances in jeopardy as well as your business.

Operating as a sole proprietor or partnership

If you are unincorporated, whether you are a sole proprietor or have partners, there is no distinction legally between your business debts and your personal debts. If your business fails and you are unable to repay any obligations, such as money owed to the bank, suppliers, employees or a landlord, those creditors will look to you for payment. It is not uncommon after a small business closure for the owners to declare personal bankruptcy or file a consumer proposal in order to eliminate these debts. Doing so, however, will also impact all of your personal finances. In other words, declaring personal bankruptcy will deal with your business debts like unsecured bank loans and even tax debts from the business, but it will also deal with your personal debts including credit cards, unsecured lines of credit and personal income tax debts.

The flip side of this is that if you have any personal assets that are not exempt from seizure by your bankruptcy trustee, these will be put at risk. This can include any equity in your home and other investments. In Canada, most RRSPs are excluded from seizure, so these are at least protected.

Beware of personal guarantees and personal credit cards

An incorporated business is, by definition, a separate legal entity. In the event of closure, the company can declare business bankruptcy to deal with any outstanding debts. The company’s assets are sold and any proceeds are distributed to the company’s creditors. Generally, creditors cannot look to you to repay any shortfall unless you have personally guaranteed those debts. Personal guarantees are not uncommon and are often required in order to obtain traditional bank financing. Once again it may be necessary to file for personal bankruptcy in order to eliminate those debts if they are substantial.

Another common practice among small business owners, whether incorporated or not, is to fund cash flow shortfalls with their personal credit cards or lines of credit. The assumption often is that this cash flow crunch is just temporary and that once the business recovers they will be able to pay down the resulting debt. Unfortunately, high interest rates and often a slower-than-expected recovery can put your personal finances at risk. Maxing out your personal credit cards will have a negative impact on your credit rating, increasing your personal cost of borrowing should you need to borrow money in the near future. And if you are unable to repay these personal debts, your business may survive, but you yourself may have to declare personal bankruptcy to take care of your accumulated credit card debt.

Maintain appropriate income tax instalments

Another common debt that often leads to personal bankruptcy among entrepreneurs and self-employed contractors is unpaid personal income tax debts, GST or withholding taxes. Business owners who have exhausted all other credit options often stop making remittances to Canada Revenue Agency in order to keep up with payroll and supplier payments. Tax debts can be included in a personal bankruptcy, including those incurred through the operation of your business. However, this can only happen if you file for personal bankruptcy before CRA has registered a lien against any personal property like your home. If CRA registers a lien prior to you declaring bankruptcy, then these debts become secured debts and cannot be eliminated in a bankruptcy or consumer proposal.

Even if your business is incorporated, if you are an officer and director of the company, there are certain debts that will follow you personally. These include HST, source deductions and employee wages. If your company closes and is unable to pay these debts from the sale of assets, any officers and directors will become liable for the full unpaid amount, and this may trigger the need to file personal bankruptcy.

More than one in 10 personal insolvencies we see involve self-employed contractors and small business owners. Consider the ripple effect that debts incurred trying to maintain a business enterprise can have on your personal financial situation.

Doug Hoyes has extensive experience resolving financial issues for Canadians. Doug is a Chartered Professional Accountant (CPA), Licensed Trustee and Chartered Insolvency and Restructuring Professional for Hoyes, Michalos & Associates.