One of the major differences between operating a business as a sole proprietor and being the director of a limited company is the commercial law relating to liabilities. In particular, a person acting as a sole proprietor is seen legally as the same entity as the business, and as such is liable for any of the debts and liabilities incurred by that business.
Conversely, under commercial law, a company director is regarded as a different legal entity to the business and thus in normal circumstances would not be liable for any of the debts or liabilities the business had. This is one of the often-cited advantages of running a business as a limited company rather than a sole proprietor, however, there is a caveat.
The protection for directors concerning a company’s debts and liabilities is not absolute, and there are actions, behaviours and circumstances that could mean a director does find themselves responsible for the cost of liabilities and obligations which were taken out in the company’s name. There are 5 specific categories of liability that a director might find themselves responsible for and they are:
- Insolvent Trading
- Phoenix Activities
- Breaching Director Duties
- Company Debts Incurred Whilst Company Is Acting As Trustee
Here are some details of each of them and why a director could face being liable for the cost of a company’s liabilities.
A person who is the director of a company is obligated to ensure that it does not trade if it is insolvent. The legal definition of insolvency is being unable to pay debts and liabilities when due. If a director fails in this duty, even if it is unwittingly, and the company continues to trade, the director may become liable personally for paying penalties and compensation that arise as a result. They could even face criminal charges.
We should make it clear from the outset this is not referring to any director having to personally fund make wage payments. Rather, it is referring to a company’s obligation to withhold PAYG and obligations relating to the Superannuation Guarantee. Failure in these could lead to charges being levied against the directors of the company.
A phoenix rising from the ashes is normally deemed a positive in most spheres given it refers to something or someone going from a dire situation to a positive one. Unfortunately, the phoenix activity here refers to activities by a director that breach commercial law. Specifically, it is registering a new company to take over a failed one that they were previously directors of.
This is designed to stop directors walking away from a failed company that leaves behind unpaid creditors, and simply creating a new legal entity to run that business but with none of the liabilities. What can lead to confusion is that there are certain scenarios where phoenix purchases are permitted, so ensure you seek legal advice beforehand, or you could find yourself disqualified as a director altogether.
Breaching Director Duties
When a person becomes a company director they commit to certain obligations which relate to acting in good faith, acting with care and with diligence, and not using their position for personal gain to the detriment of the company. Should they fail in these, or any of their other duties and obligations and it harms the company, the company’s shareholders or those liquidating the company, can sue the director for compensation relating to the losses incurred.
Company Debts Incurred Whilst Acting As Trustee
If the company is acting as a trustee of a trust, and whilst in that capacity the company incurs debts and liabilities, a director could find themselves liable for those. For this reason, a director must seek advice from their commercial lawyer who may examine the trust deed to determine whether that director is exposed to any liability and if so to what extent.