When you run a business, one of the first and most important considerations is its legal structure. In the UK, there are three main business structures for SMEs - sole proprietorships, partnerships and limited companies. The structure you choose has implications for who owns the company, how its profits are distributed and how it is taxed. It will also determine the extent of your financial liability.
Each business structure has its pros and cons. One of the main benefits of operating a limited company is something called limited liability. Here we explain what limited liability is and what it means for you as a company director.
Limited liability means the business’s shareholders and directors are not legally responsible for its debts if the company cannot afford to pay them. Their liability for those debts is limited to the money they invested in the business.
A limited company is its own legal entity and is financially separate from the people who run it. Therefore, if the company is in financial distress and cannot pay its debts, those debts do not pass to the directors. The same applies to any legal action that’s taken against the company. If a third party sues the business, the company is liable but not its owners.
Limited liability allows business owners and investors to start a business without putting their personal finances and assets at risk. That encourages entrepreneurship and is central to the health of the economy.
You must incorporate your business at Companies House to benefit from limited liability. Incorporation is the process of forming and registering a limited company. You can choose to operate as one of the following:
These legal structures are formed and run differently but all offer limited liability. LLPs, LTDs and PLCs are limited by shares. That means the liability for the owners is limited to the value of the shares they hold in the company.
Companies limited by guarantee are usually not for profit, such as charities and sports clubs. The liability of their members is limited to the guarantee amount set out in the Company’s Memorandum of Association. This is usually a nominal amount, often £1.
Unlimited liability means that there is no limit to how much the owners of a business have to pay personally toward debts or damages if it fails or is sued. It applies to sole traders and partners in ordinary partnerships.
In sole traders and partnerships, the owners of the business and the business itself are the same legal and financial entity. This added financial risk is why, as the business grows, most owners switch to a structure that offers limited liability protection.
Limited liability provides valuable financial protection for directors and shareholders if their company has debts it cannot pay. If the company cannot be saved, it will enter an insolvent liquidation process and its assets will be sold to repay the company’s creditors (parties it owes money to) as far as possible. Any debts it cannot afford to pay will be written off and liability does not pass to the shareholders or directors.
However, there are a few instances when the directors and shareholders can become liable.
Personal guarantees
Lenders often ask company directors to provide a personal guarantee for loans and other financing deals, particularly when smaller companies are involved. The personal guarantee enables the lender to pursue the director personally for the repayment if the company defaults.
If your business is struggling financially, you might be tempted to repay a debt you have personally guaranteed ahead of other creditors. However, when your company is insolvent, you must protect the interests of your creditors as a whole. Choosing to pay one creditor before another is known as a preference payment and it could lead to you becoming personally liable for a proportion of your company’s debt.
Not adhering to your duties as company director
Your legal duties as a company director change when the business becomes insolvent. At this point, you must act in the best interests of your creditors. Part of that includes seeking insolvency advice early and acting to maximise your creditors’ return. If you do not adhere to your director’s duties, you could be accused of wrongful trading and become personally liable for some or all of the company’s debts.
Fraudulent trading
Fraudulent trading could also lead to you losing limited liability protection. Fraudulent trading can take several forms, such as taking customer payments with no intention of fulfilling their orders and misusing Bounce Back Loans.
If you have been involved in fraudulent trading, you could be made personally liable for the losses suffered, risk being disqualified from acting as a company director or even receive a prison sentence of up to two years.
Limited liability is not an excuse to ignore your financial issues. If your company is struggling, you are legally obliged to protect the interests of your creditors. The best way to do that is by seeking expert advice from a licensed Insolvency Practitioner.
At Begbies Traynor, we will assess your company’s finances, discuss your options and work to put a rescue plan in place before the situation becomes more serious. If your business is no longer viable, we can guide you on whether liquidation is your best option and reduce the risks for you personally throughout the process. Call our team for a free same-day consultation or arrange a meeting at one of our UK offices.
More Begbies Traynor Articles
Contact Begbies Traynor Group
You're in Safe Hands
Article Archive
Article Categories