By Lyzz Leise
As part of this week’s Tuesday Tax Take, we are looking at a common feature of business transactions that can have very personal consequences for business owners: the personal guaranty. One of the primary reasons business owners form a corporation or limited liability company is to create separation between the obligations of the business and the personal assets of its owners. But that protection has limits. When an owner signs a personal guaranty, the owner is voluntarily agreeing to become personally responsible for an obligation of the business if the business does not satisfy it. Personal guaranties are common in commercial lending, leases, vendor credit arrangements, equipment financing, and other transactions. Before signing one, business owners should understand exactly what they are agreeing to.
What Is a Personal Guaranty?
A personal guaranty is a contractual promise by an individual to be responsible for another party’s obligation. In the business context, that typically means an owner agrees to be personally responsible for an obligation owed by the owner’s company. For example, suppose Taylor Swift, LLC obtains a business loan and its owner signs a personal guaranty. Taylor Swift, LLC remains the borrower, but the owner has separately agreed to be responsible for the debt if the company fails to pay as required. That distinction is important. Forming an LLC or corporation does not prevent an owner from voluntarily taking on personal liability. If an owner signs a valid personal guaranty, the fact that the underlying obligation belongs to the company generally does not eliminate the owner’s obligations under the guaranty.
Why Are Personal Guaranties Required?
Lenders, landlords, vendors, and other parties frequently request personal guaranties when doing business with privately held companies, particularly newer businesses or companies with limited assets or credit history. From the creditor’s perspective, the guaranty provides an additional source of repayment if the business cannot meet its obligations. From the business owner’s perspective, however, it means accepting some of the personal financial risk that forming a separate legal entity would otherwise help limit. Whether a guaranty is required, and whether its terms are negotiable, often depends on the circumstances of the transaction and the bargaining power of the parties.
Not All Guaranties Are the Same
The word “guaranty” may appear straightforward, but the scope of the obligation can vary significantly. A guaranty may be unlimited, potentially making the guarantor responsible for the full amount owed by the business. In other cases, the parties may negotiate a cap on the amount guaranteed or limit the guaranty to particular obligations. Business owners should also pay attention to what expenses are covered. Depending on the language, a guaranty may extend beyond the principal amount owed and include interest, late charges, collection costs, attorneys’ fees, and other amounts. The terms of the actual guaranty matter.
Will the Creditor Have to Pursue the Business First?
Business owners should not assume that a creditor must exhaust every remedy against the company before pursuing a guarantor. Many commercial guaranties contain broad waivers and provide that the guarantor’s obligations are direct or unconditional. Depending on the terms of the agreement, a creditor may have significant flexibility in deciding how and from whom to seek payment following a default. For that reason, owners should not view a personal guaranty merely as a backup document that is unlikely to matter. If the business cannot perform, the guaranty can become very important very quickly.
Read the Guaranty Separately
Personal guaranties are sometimes included at the end of a larger loan, lease, or credit agreement, which can make them easy to treat as just another signature line. They should not be. When signing a contract on behalf of an LLC or corporation, an owner may be signing solely in a representative capacity. When that same owner signs a personal guaranty, the owner is taking on a separate obligation individually. Before signing, business owners should understand:
What obligations are being guaranteed;
Whether the guaranty is limited or unlimited;
Whether it applies to future indebtedness or obligations;
What happens if the underlying agreement is renewed, extended, or modified;
Whether and how the guaranty can be terminated; and
What rights or defenses the guarantor may be waiving.
The Bottom Line
A personal guaranty can be a routine part of obtaining financing, leasing space, or establishing credit for a business, but “routine” does not mean insignificant. Business owners form separate entities in part to limit personal exposure to business liabilities. Signing a personal guaranty can create an important exception to that protection by making the owner personally responsible for a particular business obligation. Before signing, take the time to understand how much you are guaranteeing, how long the guaranty lasts, and what circumstances could result in personal liability. A few lines at the end of a business agreement can have consequences well beyond the business itself.
This article is provided for general information purposes only and should not be construed as legal advice. Those requiring legal advice are encouraged to consult with their attorney.
