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Legal form and liability

The shortfall when a business closes, who answers for it as a sole proprietor, a partnership or a company, and what a personal guarantee changes.

Paper packet. Every task here also exists on screen, where it is checked automatically; answers written on paper are not assessed by Nydus. When you are back at a device, enter your answers there.

1. What you will learn

You will work out the shortfall a business leaves when it closes, and say who pays it if the business is a sole proprietor, a general partnership or a limited liability company. You will also add a personal guarantee to a company owner's loss, and pay a secured lender before the other creditors.

2. What you already have

You can already keep revenue, profit and cash apart, and you know that a business can owe money it has not yet paid: a supplier's invoice, a month's rent, a loan. This lesson asks a question those lessons left aside. If the business stops trading and cannot pay what it owes, whose money pays the rest? The answer is set by the legal form the business was given when it started, and it is one of the few decisions an owner makes in the first week that can matter more than any price they ever set.

3. Words this lesson uses

4. The shortfall, and whose pocket it comes out of

When a business closes and cannot pay everything it owes, the arithmetic starts the same way whatever its form. Sell everything it owns, pay what that raises to the people it owes, and see what is left unpaid:

$$\text{shortfall} = \text{debts} - \text{what the assets sell for}$$

What the legal form decides is who answers for the shortfall.

A sole proprietor is not a separate person from the business. The debts of the business are the owner's debts, so the shortfall is paid from the owner's savings, and in the worst case from what the owner owns outside the business too. Setting up is simple and cheap, and the owner keeps everything the business earns; the price is that nothing stands between the business's creditors and the owner's home.

A general partnership is two or more people trading together. Each partner can usually be pursued for the whole of the firm's debts, not only a share. The partnership agreement says how the partners split things between themselves, and that matters, but it binds the partners, not the people they owe.

A limited liability company is registered as a person in law of its own. Its debts are its own. The owners — the shareholders — can usually lose only what they paid for their shares, which is called limited liability. The shortfall stays with the company's creditors. The price of that protection is paperwork: the company is registered, files accounts and returns, and keeps its money strictly apart from its owners'.

A personal guarantee is how a lender gets round limited liability. A bank lending to a young company will often ask its owner to guarantee the loan personally. The owner's loss is then what they put in plus what they guaranteed, and only the rest of the shortfall stays with the creditors.

Taxes, permits, registration and the records a business must keep are set where the business trades, and they differ from one place to the next and from one year to the next. So this teaches the reasoning — what a figure is for, and how to work it out — with any rate or threshold given to you in the question as a number to use. The rate that applies to you is a thing to look up with the authority where you trade, and to check again each year.

5. The method, step by step, and how to check it

Write down every debt. The supplier invoices not yet paid, the rent to the end of the lease, any loan, and any tax or wages owed. Leases are the debt people forget: a lease signed for a year is owed for the year, not only for the months already used.

Price what the business owns at what it would really sell for. A van bought for 30,000 may fetch 12,000 in a hurry; stock sold off in a closing sale fetches a fraction of its price. The shortfall is only as honest as this figure.

Pay the secured lender from its asset. A loan secured on the van is repaid from the sale of the van before anyone else sees that money. In many places some wages and taxes also come before ordinary suppliers.

Apply the form. Sole proprietor: the owner answers for the whole shortfall. Partnership: any partner can be asked for the whole, and the agreement decides what they can claim back from each other. Company: the owners lose what they paid for their shares and any guarantee they gave; the rest stays with the creditors.

Check the result by adding up where every dollar of the debts ended: paid from the assets, paid by an owner, or left unpaid. The three parts must add back to the total owed. A check that does not close means a debt was counted twice or an asset was sold twice.

6. Owner's pay, and why the form changes it

The legal form also decides what the owner's pay is in the accounts. A sole proprietor or partner does not employ themselves: what they take out is drawings from the profit, and the profit itself is what is taxed as theirs. A corporation, or an LLC that elects to be taxed as one, can employ its owner and pay a salary, which is an expense in the company's accounts.

Owner labor is three different things, and every lesson that touches it says which one it means.

The first two are always available and always used. The third depends on where the business is and what form it takes, so anything that asserts it names both.

This is why two businesses with the same trading can show different profits: one has taken the owner's wage off as an expense and the other has not. Neither is wrong. Before comparing them, put both on the same footing.

7. Choosing a form: what it costs and what it buys

A company costs more to run than a sole proprietor: registration fees, annual filings, accounts prepared to a standard, and sometimes an accountant to do them. What it buys is a limit on the owner's loss, and sometimes a different tax treatment, which depends entirely on where the business trades.

The limit matters most where the business can run up debts much larger than the owner could pay: a lease on premises, stock bought on credit, staff, equipment on finance, work that could injure someone. It matters least where the business owes almost nothing — a tutor paid in advance, a freelancer with a laptop — because there is little shortfall for anyone to answer for.

Two things narrow the gap in practice. Lenders to small companies often ask for a personal guarantee, which puts part of the risk back on the owner. And insurance can cover some of what goes wrong, such as a customer hurt on the premises, whatever the form. The next lesson prices both.

A partnership needs one thing more than the others: a written agreement before any money changes hands, saying how profit and loss are shared, what happens when a partner wants to leave, and who may sign for the firm. It cannot limit what the partners owe to outsiders, but it settles what they owe each other, which is where most partnership disputes start.

8. In the world: a builder deciding how to trade

A builder starting out on her own expects to hold a lease on a small yard at 900 a month for two years, to buy materials on thirty days' credit from two merchants — up to 15,000 owed at any moment — and to take a van on finance of 24,000. She has 20,000 of savings and owns a share of a house.

She works the bad case both ways. Suppose after a year a large customer fails to pay and she has to stop. The debts are the yard's remaining year, 12 × 900 = 10,800, the merchants' 15,000 and the van finance of about 16,000 still owed: 41,800. The van sells for 12,000, which goes to the finance company first, and the tools and stock fetch 3,000. The shortfall is 41,800 − 15,000 = 26,800.

As a sole proprietor, all 26,800 is hers, on top of the 5,000 she puts in either way: more than her savings, so her share of the house is at risk. As a company, she loses the 5,000 she would put in for shares and whatever she guarantees. The van finance company asks for a guarantee on the 4,000 the van's sale would not cover; the merchants and the landlord do not. Her loss is 5,000 + 4,000 = 9,000, and 22,800 stays with the creditors.

The company's filings and accountant will cost her perhaps 1,500 a year. She weighs that against a difference of 26,800 + 5,000 − 9,000 = 22,800 in the bad case, and against how likely the bad case is. That is the whole of the decision the arithmetic can settle; the tax side she checks with the authority where she trades.

9. In the world: why banks ask for guarantees

Banks lending to small companies know that limited liability shifts the shortfall onto them if the company fails. A personal guarantee from the owner shifts part of it back, and it also tells the bank that the owner believes in the business enough to stand behind it. For the owner, the useful habit is to write down, for every guarantee signed, the most it could cost, and to add those amounts up: that total is the real limit on what the company form protects.

10. Where this goes wrong

Thinking a partner only owes a share. The agreement's split binds the partners, not the landlord or the supplier. A creditor can usually go to whichever partner can pay.

Thinking a company means no personal risk. A personal guarantee brings part of it straight back, and so does mixing the company's money with your own.

Forgetting the money already put in. A company owner who put in 10,000 for shares has lost that 10,000 when the company closes, even if they owe nothing more. It counts in their loss under every form.

Pricing the assets at what they cost. The shortfall uses what the assets sell for now, which is usually much less.

Treating the legal form as a tax question only. Tax treatment varies from place to place and changes; who pays when things go wrong is the question that decides whether a bad year costs the business or the family home.

11. A café closes as a sole proprietor

1. List the debts: suppliers 6,000, rent to the lease's end 9,000, loan 15,000.

   $6000 + 9000 + 15000 = 30000$

   Every debt, including the months of rent not yet used.

2. Price the assets at what they would fetch: equipment and stock.

   $11000 + 1000 = 12000$

   Not what they cost; what a buyer would pay now.

3. Find the shortfall.

   $30000 - 12000 = 18000$

   What selling everything does not cover.

4. Apply the form: the owner is the business.

   $\text{the owner answers for } 18000$

   From savings, and if those run out, from what the owner owns.

5. Check that every dollar owed is accounted for.

   $12000 + 18000 = 30000$

   Paid from the assets plus paid by the owner equals the total owed.

12. Two partners and a loss they split unequally

1. Find the shortfall: debts 50,000, assets 20,000.

   $50000 - 20000 = 30000$

   The same arithmetic as for one owner.

2. Apply the agreement's split of 2 to 1.

   $30000 \times \tfrac{2}{3} = 20000; \quad 30000 \times \tfrac{1}{3} = 10000$

   How the partners share the loss between themselves.

3. Say what a creditor can ask the first partner for.

   $\text{up to all } 30000$

   The creditors are not bound by the split.

4. Suppose the second partner cannot pay: the first pays the lot.

   $20000 + 10000 = 30000$

   Her own share and her partner's.

5. Work out what she can claim back.

   $30000 - 20000 = 10000$

   A claim, worth only what the other partner can one day pay.

6. Check the partners' final positions add to the shortfall.

   $20000 + 10000 = 30000$

   Whoever paid first, the agreement settles the final split.

13. The same business as a company with a guarantee

1. Note what the owner paid for her shares.

   $10000$

   Gone with the company, whatever else happens.

2. Find the shortfall: debts 50,000, assets 20,000.

   $50000 - 20000 = 30000$

   It is the company's shortfall, not hers.

3. Pay the loan secured on the oven from the oven's sale of 8,000.

   $\text{loan } 12000 - 8000 = 4000 \text{ still owed to the bank}$

   The secured lender takes its asset's price first.

4. Apply her guarantee of 5,000 on the bank loan.

   $\min(4000, 5000) = 4000$

   A guarantee is called in only for what is actually unpaid.

5. Add up what leaves her own pocket.

   $10000 + 4000 = 14000$

   The share money plus the guarantee that was called.

6. Find what stays with the other creditors.

   $30000 - 4000 = 26000$

   Limited liability means this is not hers to pay.

7. Compare with running it as a sole proprietor.

   $(10000 + 30000) - 14000 = 26000$

   The company form kept 26,000 of the loss off her; it is what the filings bought.

14. Your turn: debts of 40,000, assets that sell for 15,000, a guarantee of 6,000

1. Find the shortfall.

   $40000 - 15000 = 25000$

   Debts less what the assets fetch.

2. Say what a sole proprietor would owe of it.

   $25000$

   All of it.

3. Your turn: work this step out. Its working is at the end of the packet.

   Say what the company owner pays beyond her shares.

15. Guided practice

Match each description to the arrangement it describes.

16. Guided practice

Complete the worked solution: a business closes owing $35$ thousand dollars, and everything it owns sells for $13$ thousand. Work out who pays the shortfall if it was a sole proprietor, two equal partners, or a company whose owner guaranteed $8$ thousand of its debts.

1. Find the shortfall the assets leave.

   $35 - 13 =$ _s

   It is what selling everything the business owns does not cover.

2. Say what a sole proprietor owes of it.

   $\text{sole proprietor: all of the shortfall} =$ _p

   Owner and business are one person, so the shortfall falls on the owner's savings.

3. Split it between two equal partners.

   $(\text{shortfall}) \div 2 =$ _e

   Their agreement shares losses equally between themselves.

4. Say what one partner can be pursued for.

   $\text{up to all of it, if the other partner cannot pay}$

   The agreement binds the partners to each other, not the creditors.

5. Take the guarantee off the shortfall for a company.

   $(\text{shortfall}) - 8 =$ _c

   The owner pays the guarantee; the creditors go without the rest.

17. Guided practice

Ines paid $18$ thousand dollars for her ownership stake in her own bakery LLC and personally guaranteed $6$ thousand of its bank loan. The company closes owing $78$ thousand in all, and everything it owns sells for $22$ thousand. How many thousand dollars does Ines lose altogether, counting what she paid for the shares?

Answer:

18. Practice

Ana and Ben run a van-rental business as a general partnership and share profits and losses equally. Ben signs a year's lease on a yard for the vans at $1100$ dollars a month, without telling Ana. The business stops paying the rent. Who can the landlord pursue for the unpaid rent?

• Either partner, for the whole of it
• Only Ben, because he signed without asking
• Each partner for half, as their agreement says
• Neither, because the partnership is a person of its own

19. Practice

A delivery company closes. Its van and everything else it owns sell for $24$ thousand dollars. It owes $9$ thousand on a loan secured on the van, and $37$ thousand to ordinary suppliers; it owes no wages or taxes. How many thousand dollars do the suppliers receive between them?

Answer:

20. Practice

Sam is choosing how to set up a catering business and will put in $7$ thousand dollars either way. Suppose it later closes owing $48$ thousand, and everything it owns sells for $11$ thousand. As a company, Sam would have personally guaranteed $8$ thousand of its bank loan. Fill in what Sam loses under each form, in thousands of dollars.

21. Somewhere new

Two partners' hairdressing business closes $20$ thousand dollars short once everything it owns is sold. Their agreement shares losses 60 percent to Mara and 40 percent to Joel. Joel has no savings to pay with. Fill in the sheet, in thousands of dollars.

22. Lesson test

Lesson test: one question per skill, one attempt each, no hints. Your answers are checked when you submit.

23. Test question

Sam is choosing how to set up a catering business and will put in $11$ thousand dollars either way. Suppose it later closes owing $31$ thousand, and everything it owns sells for $21$ thousand. As a company, Sam would have personally guaranteed $5$ thousand of its bank loan. Fill in what Sam loses under each form, in thousands of dollars.

24. What you can do now

You can find the shortfall a closing business leaves and say whose pocket it comes out of under each legal form. Tell someone why a partnership agreement that splits losses equally does not stop a creditor asking one partner for all of it. Next: what registering, licenses and insurance cost, and what they are worth.

Working for the steps left to you

14. Your turn: debts of 40,000, assets that sell for 15,000, a guarantee of 6,000, step 3