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Establishing a limited company involves a little more in the way of formation than being a sole trader, as well as higher economic and admin duties, there are certain benefits one of which is limited liability.' As the name indicates, any liability of a limited company usually does not extend beyond the organization of the business itself. Although shareholders are usually always protected against liabilities, directors (often also shareholders) may sometimes be liable for financial debts.
What does liability mean?
This is any amount of cash or debt that a company owes, i.e. an unpaid invoice to a wholesaler (if you are a distributor), a bank loan, an HP agreement, or any other amount of cash that your company may pay to its lenders.
What is meant by limited liability?
This is the protection provided to a limited company's shareholders, which means that if the company is unable to pay its debts, it cannot be held personally liable. While directors are often shareholders as well, the protection of limited liability ' applies to their status as shareholders. If things go wrong and debts spin out of control, sole traders can be held personally responsible.
What are the situations under which the directors are liable for debts?
There are certain circumstances in which the directors of a limited company (whether or not they are also shareholders) can be held liable for their debts. Following are a few examples of how this can occur:
1) By getting an overdrawn director's loan account: a director's loan account enables the director to take money out of his business in a way that is not a salary, expense or dividend. If this appears, it should be logged in and, eventually, the amount should be repaid. Of course, if you take out more than you pay in, the loan account will be overdrawn. Usually, if it's under £10,000 it's not a problem. However, if a business faces insolvency, the circumstance can get more complex as the cash account of the director is then considered as business assets and a director will have to pay back the cash they have borrowed so that any creditors can be paid.
2) By signing a Personal Guarantee of a Director: as directors are often also shareholders and owners of a business, it is not unusual for banks, landlords or suppliers to allow the director to sign a personal guarantee before expanding the loan or agreeing to a loan. It is worth considering taking out personal guarantee insurance, which can offer you peace of mind whenever you want to sign a personal guarantee to obtain your company goals.
3) By engaging in wrongful trading: Wrongful trading is covered in Section 214 of the Insolvency Act 1986 and is a civil offence. It can be defined as' irresponsibly' trading. This occurs if a director continues to trade, even though they knew or ought to have known, there was no chance of avoiding insolvent liquidation. Furthermore, directors must take measures to reduce the potential loss to the creditors of the company. Wrongful trading can only apply in terminal insolvency, i.e. when a company is no longer feasible, and formal insolvency proceedings (such as liquidation or administration) have already started. It means that if a company becomes insolvent, the directors have a statutory obligation to act in the best interests of the creditors of the company and cannot carry out any antecedent transactions that go against it. If they do so, they might become personally liable to contribute to the assets of the company. Therefore it is advisable to seek guidance from insolvency specialists if your company is ever getting into an insolvency situation; in this manner, it is possible to guarantee that any action is suitable to the condition.
4) By engaging in fraudulent trading: this occurs when a company's director unfairly continues business with the intention of defrauding its creditors or for another fraudulent purpose (in contravention of Section 993 of the Companies Act 2006).
5) Breaking a fiduciary duty: Company directors have what is referred to as' fiduciary duties' which means that if the business is insolvent, they must act in the interests of their creditors. Therefore, if a director acts to a creditor's detriment, they might incur liability for debts.
6) Launching a new company with a comparable name to an insolvent one: sometimes a company may try to continue trading by setting up a new company, sometimes with a comparable name, even though the earlier one has been liquidated. This is known as the syndrome of Phoenix. If this occurs, a director can be held liable for any debts of the new company.
What are the antecedent transactions?
An antecedent transaction is one carried out by a business that is at risk of being challenged and overturned after the business being placed into insolvency. If a business stops trading and goes into liquidation, directors may not carry out operations that undermine the position of its creditor.
For example, by making a preferential payment to one creditor over another, or by selling an asset for less than what it's worth, thereby reducing any creditor's return. This also involves not paying dividends to shareholders, as this is only legitimate when adequate distributable profits are available.
Another common form of antecedent transaction is an' undervalue' transaction. A transaction is usually regarded to be undervalued if the business makes a gift to an individual or enters into a transaction without receiving anything for it, or if the business gets remuneration that is considerably less than the real value of the transaction should be.
Section 238(1) of the Insolvency Act 1986 states that where a business enters liquidation and, within the proper time (two years before the date of liquidation), enters into such a transaction, the liquidator can apply to the court for an order either to reverse the transaction or to recover the losses of the company from the directors.
What is the major reason for an overdrawn director's loan?
The most prevalent reason that a director's loan account might be overdrawn is because of the recommendation of the accountant, that a minimum wage is drawn to maintain taxes and national insurance law. The rest of the payment is taken as dividends.
This may be difficult; however, if the company suddenly hits a cash-flow issue and the company has to close. Often, the director who has been using the director's credit account to draw a wage will not even be conscious of the consequences of being overdrawn at this point when it's too late to fix it.
If you have a limited company and the business fails, will you still be liable to pay National Insurance and PAYE?
Yes, this is one of the exceptions to the security offered by a limited company, and directors can be made liable for their payments for PAYE and National Insurance.
What are the fiduciary duties of directors when a company becomes insolvent?
The company has a statutory obligation to act in the best interests of its creditors as a whole and the directors must do all they can to make sure that the repayments of all creditors use the company's resources.
What are the steps that can be taken to prevent personal responsibility for the debts of a company?
The risk of being liable for the debts of a limited company is higher if it is insolvent or near insolvency. For this reason, it is prudent to seek professional advice if you are ever faced with this scenario. This will help you to make sure that steps are taken to reduce the opportunity that you will be made personally liable for any debts, including:
- Putting creditors' interests ahead of your shareholders.
- Maintaining open communication with any creditors.
- Manage debt and avoid falling further into debt or collecting new creditors.
Can you keep trading to try and save your business, even if it risks making the situation tougher?
If insolvency is a certainty, directors can be personally liable if they continue trading. Thus, to avoid liability as a director, you would have to prove that you reasonably believed that your business could be saved and that you did all you can to reduce loss to creditors. However, if you keep taking credit from business associates, knowing that it probably won't be paid back, you open yourself up to the risk of being personally liable for wrongful trading.
