Nobody wants to think about debts, but the fact of the matter is that it’s always been a part of business (and likely always will be!). Sometimes, debt can become insurmountable for a limited company or a sole trader, but is a company director liable for its debts?
This depends on the situation, and doesn’t have a simple yes/no answer. In this article, we’ll run through what happens when a business is unable to repay debt, and when a director is/isn’t liable for repayments.
What is a business liability?
A ‘liability’ is, put simply, a sum of money that a company owes. Any loans, invoices or other agreements that remain unpaid are considered liabilities, so it’s important to understand what you’re responsible for as the director of a company.
Liability for a limited company
Limited companies enjoy limited liability. In this scenario, director liability and company liability are separate; the company is considered its own legal entity and the directors aren’t legally required to pay off all debts should the company become insolvent. Shareholders, directors and anyone else invested in the company are only legally obliged to pay debts to the extent of the nominal value of their shares. Essentially, once all limited debts are covered, any excess debt that the company owes vanishes with the company.
Liability for a sole trader
As a sole trader the situation is quite different. A sole trader is legally considered inseparable from their business, which means that their business’ debts are their own, and even if the business becomes insolvent, the individual still has to repay the debts. This means that sole traders could end up liquidating personal assets. Sole traders in this situation will need to consider personal insolvency options like bankruptcy or IVAs.
Business debt liability in partnerships
There are two main types of partnerships to be aware of: limited partnerships and limited liability partnerships.
A limited liability partnership works similarly to the limited liability companies we discussed earlier – in this instance, each individual partner is only liable up to the amount that they invested into the business. Any debts owed over that amount are considered legally the business’ and cannot fall to the partners to pay in the form of personal assets or income.
On the other hand, a limited partnership works slightly differently. In a limited partnership there are two parties: at least one general partner, and at least one limited partner. The general partner(s) will take on full control of the business, which means they also take on full liability if the partnership isn’t able to pay its debts.
Limited partners are only required to pay business debts up to the amount of their initial investment (as long as they don’t take part in management or control of the partnership).
When can a director be held personally liable in the UK?
Limited liability doesn’t protect directors absolutely, there are a handful of situations where directors can be held liable for their limited company:
- If you’ve signed a personal guarantee
- When debts are fraudulently accumulated – if directors over-borrow when they know they can’t afford it, for example
- If director misconduct causes the company to become insolvent
- If a director pays shareholders from an insolvent company rather than repaying creditors
- By disposing of company assets illicitly, or for significantly less than their actual value
- If evidence of misfeasance is found (using company funds for personal activities)
- If a director’s loan account becomes overdrawn - This isn’t a problem if properly recorded and repaid; it only becomes an issue when a business is insolvent, and the overdrawn amount becomes unpaid debt. This debt is then considered the director’s
Evidence of malpractice can result in director(s) being held legally responsible for a company’s debts in the UK, but director liability usually happens as the result of a personal guarantee.
What is a personal guarantee?
Any unsecured borrowing will likely require a personal guarantee to be approved. Banks are incredibly unlikely to lend money to start-ups or businesses with little provable history (or even established businesses with a poor credit history). This means that, in most situations, a personal guarantee is required in order to secure funding to provide security for the lender.
A personal guarantee is, as the name suggests, a guarantee from an individual that overrides limited liability. Should the business become insolvent, then the director who signed the personal guarantee is required to pay all debts. Unfortunately, a director whose company is in dire straits will often be struggling for money, which means that, in most situations, their assets (houses, cars, etc.) will be used to cover any money that’s owed.
How to avoid personal liability as director of a company
Insolvency rarely comes out of nowhere. It’s important that you’re realistic about your business’ forecast. If you’re worried about insolvency, then it’s important to take proactive measures to ensure you’re not liable. Insolvency practitioners will be diligently looking for evidence of wrongful trading, the details of which can be found in Section 214 of the Insolvency Act. In order to protect yourself, you should:
- Always ensure that your creditors’ interests are placed first, and never give preferential treatment to one creditor over another
- Maintain communications with creditors and shareholders throughout
- Pursue every avenue for new business and take every effort to carefully manage your debts
- Seek professional advice to make sure you are doing everything possible to avoid insolvency
Failure to adhere to these rules can have dire consequences. Directors can face significant financial penalties, and even jail time in particularly serious circumstances. Usually, a director will also be disqualified from performing directorial roles for another limited company.
Personal Guarantee Insurance with Purbeck
Directors have a lot on their plates from the outset, but there’s no reason that your personal guarantee should be a source of stress. At Purbeck, we understand that it’s more than your signature on the dotted line when it comes to personal guarantees. We offer personal guarantee insurance to help SME directors who have business loans or other financial agreements. Not all businesses succeed, and in the unfortunate event that your business collapses, insurance will protect your home and other assets, allowing you to rebuild.
We work closely with directors across the UK, providing key support and peace of mind, allowing you to focus on the most important thing – making your business a success. Contact us today to get in touch with one of our specialist underwriters. We’re on hand to advise on the best route to take to suit your business.