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When do directors have to pay their business’s debts?

One of the main reasons people choose to incorporate their businesses is to create a financial separation between the business and themselves. If a limited company fails, then under normal circumstances, the directors and shareholders of the company are not liable for its debts. Instead, the business enters insolvent liquidation and any debts it cannot repay from the sale of assets will be written off. 

However, that’s not always the case. There are instances when a company director can become liable for a business’s debts. Here we explain when that can happen and the likely consequences if you have to foot the bill.

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How are company debts usually paid on liquidation?

An insolvent company can enter liquidation voluntarily via a Creditors’ Voluntary Liquidation or be forced into Compulsory Liquidation by a creditor. In both cases, a liquidator is appointed to take control of the company’s affairs and close it down. 

As part of the process, the liquidator values and sells the business’s assets to generate funds to repay the creditors. They then pay the creditors in a statutory order of priority. Once all the money has run out, any debts the company cannot repay are written off and it is removed from the official register. However, there are some instances when a liquidator can make company directors liable to pay some or all of the company’s debts.

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When can a director become personally liable for company debts?

There are several scenarios when a director can be made personally liable for the business’s debts during insolvent liquidation. Here are some examples:

Personal guarantees

The most common way a director becomes liable is through a personal guarantee they have signed to secure a credit transaction. If the company cannot afford to repay the money on liquidation, you become liable according to the terms of the guarantee. If you do not pay what you owe, the creditor can pursue you through the courts and your personal assets could be at risk.

Directors’ loan accounts

Directors can borrow money from the company via a director’s loan account. However, if a director’s loan account is overdrawn when the business enters liquidation, it becomes an asset of the company and the liquidator can pursue you to repay it.

Unlawful dividend payments

Companies can only pay dividends on profits. If a company that is insolvent or nearing insolvency pays a dividend, the liquidator can ask you to repay it for the benefit of the creditors.  

Wrongful trading

When your company becomes insolvent, you have a legal duty to protect the interests of your creditors. In practice, that usually means ceasing trading to prevent further losses. If you continue to trade and worsen your creditors’ positions, you could become personally liable for those debts.

Antecedent transactions

Antecedent transactions are transactions you enter into that negatively affect the company’s financial position. Examples include making preferential payments to certain creditors but not others. Gratuitous alienation, where you sell a company asset to a connected party for less than its true worth, is another example of a transaction that can lead to personal liability issues. 

Fraud and misrepresentation

You could also become personally liable for company debts if the liquidator finds that you have deliberately defrauded your creditors. An example is lying when applying for credit on the company’s behalf.

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While all three closure options have their advantages and disadvantages, the right one for you will depend on a number of factors including the current financial position of the company and your plans for the future.

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What are the consequences if I become personally liable for company debts?

If you are made liable for company debts, you may have to use savings or sell or refinance personal assets to pay what you owe. If you do not pay, the liquidator can take court against you. As with any personal debt, you may have to consider personal debt solutions such as a Trust Deed or Debt Arrangement Scheme if you cannot pay. You could even face Sequestration.

As well as being made personally liable for company debts, you could also be disqualified from acting as a company director for up to 15 years. In cases of fraudulent activity, you could even receive a prison sentence.

How can I avoid becoming personally liable for company debts?

To reduce the risks, you must show that you have met your legal duties as the director of an insolvent company and have taken proactive steps to minimise creditor losses. You can do that by ceasing trading and contacting a licensed Insolvency Practitioner as soon as you think your company is heading towards insolvency.

If you are worried about the future of your business or think your company is already insolvent, we can advise you on your next steps and help to protect your position personally. Get in touch today for a free, same-day consultation or arrange an in-person meeting at one of our offices in Scotland.

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