When you are running your own business, you can choose to operate as a self-employed individual or through a limited company. Many clients prefer the company option because it provides an extra layer of protection. However, when it comes to finances, can a director be held responsible for the company’s debt?
What’s the difference between a sole trader and a limited company?
As a sole trader, there is no legal distinction between you as an individual and your business affairs. This means that any debt incurred by the business is essentially your own personal debt.
On the other hand, a limited company is considered a separate legal entity from its directors. If a limited company takes out a loan or other form of borrowing, the company is responsible for making the necessary monthly payments to fulfil the terms of the finance agreement.
What occurs when a limited company becomes insolvent and cannot repay its debt? Can a director be held responsible for a company debt? This is a very common question we get asked.
How much of the liability is limited?
In the event of insolvency, the feature of limited company incorporation known as ‘limited liability’ becomes extremely important. Limited liability means that a director’s liability for company debt is limited to the value of their shares.
This essentially protects you, as a director, from becoming responsible for your limited company’s debts in the event of insolvency.
When a company is unable to meet its financial obligations and becomes insolvent, it often has to undergo formal insolvency proceedings to deal with the situation. If the company’s insolvency ultimately results in liquidation, any outstanding debts that cannot be repaid during the liquidation process will be legally forgiven and effectively wiped out along with the company.
Understanding personal guarantees
When a company becomes insolvent, the director may be held personally liable for its debts if they have provided a personal guarantee.
Lenders often require personal guarantees when lending to start-ups or companies with limited trading history. It is also common for companies with a history of loan defaults to be asked for a personal guarantee to secure future loans.
A personal guarantee essentially makes the guarantor (or you as a director) responsible for repaying the money borrowed should the company be unable to do so.
When a company becomes insolvent and goes into liquidation, the personal guarantee comes into effect. This means that the individual who provided the guarantee will be responsible for repaying the outstanding balance using their own personal funds.
However, repaying the balance on a personally guaranteed company loan may not be possible, especially for a director who is recovering from the financial impact of their business becoming insolvent.
In this situation, directors have two main options.
- They can negotiate with the lender to come to a mutually agreeable repayment plan for the outstanding amount owed,
- or they may need to consider personal insolvency options such as an IVA or bankruptcy. The appointed licensed insolvency practitioner will be able to discuss the possible options and help to identify the most appropriate solution for directors in this position.
So, there are occasions when a director can be held responsible for company debt.
Wrongful trading and directors responsibilities
We often associate wrongful trading with fraud. However, the definition is quite different for directors whose companies are struggling.
When a company becomes insolvent, its directors have several legal duties and responsibilities, one of which is to prioritise the interests of creditors and minimise any further losses. As the company’s custodians, the directors are responsible for looking out for warning signs of insolvency.
In practice, this means that you need to seek advice from insolvency experts as soon as it becomes clear that the company is insolvent. Basically, this means when the company is unable to pay its debts.
When a company continues to engage in business operations while aware of its insolvency, it violates the director’s duties and may be deemed as wrongful trading.
If found guilty of wrongful trading, directors can be held personally liable for the losses suffered by creditors from the moment they knew or ought to have known that the company was insolvent.
So it’s important to remember that even though limited liability protects directors from personal liability, they should still be cautious when giving personal guarantees or continuing to trade while knowingly insolvent.
Both actions will lead to significant personal financial obligations if the company needs to be liquidated.
Do you need help?
As a company director, you have various duties to consider. You must exercise reasonable care and skill to run the company and ensure its continued success.
It is important to recognise that you may not possess all the financial skills and knowledge necessary to manage your business effectively. After all you didn’t go into business because you were good with figures. You had other skills and ideas. Therefore, it is crucial to collaborate with a reliable accountant who can provide the essential financial insights to guide your business in the right direction.
If you are currently a client of ours and you have any concerns related to the points mentioned here, please do not hesitate to contact your usual representative. If you are not yet working with us but are looking for someone to support you in your business, have a look at how we work