If you’re a director of a limited company whose business is struggling to pay its bills and wondering if insolvency is your only option, you might be concerned that you could be made personally liable for your business debts.
One of the main reasons people form a private limited company or an LLP is to limit liability for company debts. However, there are some circumstances in which you can be held personally liable, meaning the responsibility for covering the debt falls to you.
In this article, we’ll explore the rules, regulations and laws around directorial liability. These include not just being held financially responsible for corporate debt, but in some cases criminally responsible, if your actions are deemed fraudulent or dishonest
When a limited company is insolvent, the business is bankrupt and therefore unable to repay debt due to a shortage of cash. When setting up your business you have two main ways in which you can choose to operate; you can take on work as a sole trader, or alternatively you can incorporate as a private limited company. Both structures have their own pros and cons, however, the main benefit of operating as a limited company is that your business will be seen as its own separate legal entity, something which can be vital should the company run into financial difficulties further down the line.
What is a liability?
In business terms, a liability often refers to a sum of money or other debt owed by a company. This could take the form of a loan, hire purchase agreement, or an invoice which remains unpaid. It is often said that a huge advantage of operating as a limited company is that of limited liability. But what does limited liability actually mean? Simply put, limited liability is a layer of protection placed between the company and its individual directors.
This means the directors cannot be held personally responsible if the company is unable to pay its debts. Effectively this means that directors generally cannot be held personally responsible for the debts of a limited company unless they have signed personal guarantees.
Can Company Debts be Written Off?
Business liabilities will be written off should the company enter a formal insolvency procedure such as a Creditors’ Voluntary Liquidation (CVL). Any outstanding creditors are not allowed to demand the company director make payments from his or her own personal finances to pay back this money.
The funds raised from the sale will be used to pay for the liquidation process, and any funds left over will be distributed equally amongst the creditors. Any remaining unsecured company debt is then written off. Essentially the debts of the company die with the company.
When Might a Director be Held Personally Liable for Company Debts?
- You sign a personal guarantee
- You over pay yourself using company funds and create an overdrawn director’s loan account
- You continue to trade for the benefit of the shareholders despite knowing the business is insolvent
- You sell the assets of an insolvent company for less than their market value
- You raise funds to repay creditors via fraudulent means
- You fund the business with credit cards or personal loans
If you have not been involved in any of the above, your liability for company debts will be limited to the amount of money you personally invested in the business. If your business becomes insolvent and enters into an insolvency procedure or liquidation, your creditors will only be able to recover the money they are owed through the business’s bank accounts and the sale of its assets.
When Do Directors Become Personally Liable?
Directors become personally liable to contribute to the company’s assets and to help meet the deficit to unsecured creditors when they decide to continue to trade and in doing so worsen the company’s finances, rather than opting to put the company into liquidation straightaway. Put simply, the corporate veil can be lifted or pierced and all protections afforded by the veil are removed. Consequently, directors may face claims for ‘wrongful trading’ made against them personally and possibly even become disqualified for their actions.
With insolvency looming, directors should take note of the following:
· The director’s culpability is based on the information that was known or should have been known at the relevant time, and the court will consider each director’s conduct in this light.
· Person liability for company debts can also apply to non-executive directors. Even when a director only attends board meetings as he or she still has a role to play in the decisions about the company and will be judged accordingly.
· Resignation as a company director is not a solution once the issues have emerged and should only be considered if a director’s views are being ignored.
What Is Wrongful Trading and Directors Liability?
Liability for wrongful trading falls on the director if she/he knew (or ‘ought reasonably to have concluded’) that there was no reasonable prospect of avoiding the firm entering insolvency. If despite this knowledge, the directors continued trading and incurring debts, there is liability.
In deciding whether a director took every step to minimise the loss to creditors, the court places the onus on the director. This is due to the assumption that the director knew that there was no reasonable prospect of the company avoiding the insolvent liquidation. However, this liability holds even if in fact the directors did not know or claim not to have foreseen the outcome. It’s what they ought to have known that is important.
The aim of the wrongful trading laws is to make directors of companies that are getting into financial trouble, who might otherwise try to trade out of trouble, stop and think carefully about whether they are being over-optimistic about the company’s prospects.
A director is likely to end up with personal liability if they knew or ought to have known the direction the company was headed but did little or nothing to minimise the impact to creditors.
The company may use shareholder agreements which outline directors have to contribute to assets or security for the company’s debts other than by an express personal guarantee, which directors remain personally liable for. If any part is unclear, early legal advice should be taken.
Selling assets for less than market value
If a company is in financial difficulty, it might be tempting to have a ‘fire sale’ and try to sell assets quickly to raise funds. However, it’s important to remember that during and in the lead up to insolvency, the creditors’ interests must take priority. That means all assets must be sold at market value.
If the business does enter a formal insolvency process, using insolvency law, transactions at an undervalue insolvency act 1986, the transactions that have taken place will be scrutinised. If any assets are found to have been sold at undervalue, the court can order the transaction to be set aside. The directors can also be held personally liable and ordered to make a financial contribution to the company.
Example, if a company is insolvent and a director sells a company property to a family member for a less-than-market rate, it could result in personal liability for the amount missing.
Personal / Secured Guarantees
Directors are often required to provide personal guarantees in loans to reassure the lender that the debt will be paid, if, for whatever reason, the company is unable to pay. If that happens, the lender could enforce against the director’s personal assets and property. Entering a personal guarantee can potentially cause conflicts of interest between the director and company’s interests which may need careful management to avoid breach of duty. A director may be seen to be biased on account of that personal liability.
Section 239 of the Insolvency Act refers to the situation of one creditor receiving preference over another.
Example, should the director pay one supplier – on the basis of long and trusted relationship – post become aware of the company’s insolvency, he/she could find themselves personally liable as, overall, the creditors find themselves worse off.
Are Directors Personal Liability for VAT in Liquidation?
HMRC taxes such as VAT and Corporation Tax are generally limited company debts. But directors may be held personally liable if HM & Revenue discover evidence of a ‘deliberate’ avoidance of paying. Where HMRC establishes that errors are ‘deliberate’ or ‘deliberate and concealed’ it can render the associated parties 100% liable, on a personal basis.
If a company becomes insolvent and the director starts a new one, they may also ask for security bond for future VAT payments or PAYE from that individual, based on past record.
Overdrawn Director’s Current Account
If a company is doing well, directors can pay themselves a small salary and withdraw dividends from profits. They are charged at a low tax rate of 7.5% for dividends up to £46,351 and 32.5% above that level, the idea being that it incentives and rewards directors for making profits.
If the company starts to struggle financially and the director(s) continue to withdraw dividends, this is where problems begin. The tax rate effectively becomes higher yet many directors do not realise this, so they continue withdrawing dividends. By being taxed too little, they are essentially therefore in debt to HMRC. This pattern can spiral out of control and eventually produce a large overdrawn directors’ loan account. If the company becomes insolvent, the director will likely be ordered to pay back everything they owe to creditors, making them personally liable for the debt. However a deal can be done with the insolvency practitioner depending on the circumstances.
Sole Traders and Liability for Business Debts
If you are operating as a sole trader, the situation with business debts is different. As a sole trader there is no legal distinction between yourself and your business, therefore any debts your business accumulates will be classed as personal liabilities. Ceasing trading and closing down your business will not wipe out your debts, and you will be expected to continue paying them using your personal finances.
Should your sole trader business run into financial difficulties and you find yourself unable to keep up with your obligations to suppliers, HMRC, or your debt repayments, there are still options out there for you, but they differ to those available for directors of limited companies. Instead of looking at company liquidation, you will need to consider personal insolvency options such as IVAs and bankruptcy.
Partnerships and Liability for Business Debts
A partnership can be run in two ways: either as a limited partnership, or a limited liability partnership. The structure chosen determines how company debts are treated should the business be unable to con
tinue trading. A limited liability partnership enjoys the same protection of limited liability that a limited company does. This means the individual partners will not be expected to pay any debts the company is unable to.
However, if you operate as a limited partnership, the rules are different. A limited partnership is comprised of at least one general partner, and one limited partner, and in English law are not viewed as their own legal entity. While the limited partner will have limited liability for the debts of the company, the general partner will assume liability in the event of the partnership being unable to meet its financial obligations.
How We Can Help
If you are looking to close your company and are worried about being liable for your company’s debts, we can help guide you on the best way forward and let you know what you could be liable for. Utilising our licensed insolvency practitioners, we have all the expertise and experience to help guide you through what can be a tricky situation.