What happens to sole trader and limited company debt when a business closes?
When you first set up your business, you may wonder whether to run it as a sole trader or set up a limited company. The tax and accounting obligations of limited companies are more complex, but they also come with some compelling benefits, including what happens to debts if the business fails.
Sole traders
As a sole trader, the business and its owner are legally and financially the same. There is no separation between them, so those who own and operate the business are personally liable for its debts.
Parties the business owes money to, such as suppliers, lenders and HMRC, can pursue the business owner to repay a debt. If the business owner cannot pay, their assets, including their home, could be at risk. They may also have to use personal insolvency solutions such as IVAs and bankruptcy.
Limited companies
Debt is dealt with very differently if you run a limited company. Limited companies are separate legal and financial entities from those who own them. So, if a company cannot pay its debts, they do not automatically pass to the directors or shareholders personally.
Instead, you benefit from something called limited liability. If the company fails with outstanding debts, all the owners stand to lose is their original investment in the business. As long as the directors meet their legal duties and close the company correctly, its debts will be written off and the creditors will not be able to pursue the directors personally.
How do I close a company with outstanding debts?
If your limited company has debts it cannot pay, it is insolvent. To close an insolvent company, you must use a formal liquidation procedure to ensure the debts are dealt with properly. There are two liquidation procedures insolvent companies can use:
- Creditors Voluntary Liquidation (CVL)
A Creditors’ Voluntary Liquidation is a procedure you can initiate voluntarily by appointing an Insolvency Practitioner. Acting as the liquidator, they take control of the business, sell its assets and use the proceeds to repay its creditors in a pre-determined order. They then close the company and any outstanding debts are written off.
Your creditors can also take steps to force your company into Compulsory Liquidation if you do not pay what you owe. The court will appoint an Official Receiver to liquidate the company and repay its debts as far as possible. Any outstanding debt will be written off if you have met your legal duties as a company director.
What happens if you Strike Off a company with debt?
You can only use an informal company closure method like Strike Off (also known as Voluntary Dissolution) to close a business that can pay all its debts. If you try to Strike Off an insolvent company, it can cause serious problems.
When you apply to Strike Off a business, Companies House puts a notice in the Gazette to inform interested parties, including any creditors. Those creditors can file an objection to your Strike Off, and Companies House will temporarily suspend the process while it investigates. If it upholds the objection, the Strike Off will not proceed until you have resolved the creditor’s claim.
Even if no one objects and you successfully Strike Off a company with debts, your creditors can still apply to restore the business to the register to pursue a claim. Attempting to Strike Off a company with debts can also lead to investigations into the conduct of the directors and potential penalties, including personal liability for the business’s debts and director disqualification.
What debts may not be paid when a company closes?
When you close a company using an insolvent liquidation procedure, the liquidator will sell the business’s assets and seek to recover money from its debtors. That can include unpaid customer invoices and overdrawn director’s loan accounts. Their aim is to maximise the return for the creditors.
They then repay the creditors in a prescribed order as set out in the Insolvency Act 1986:
- Secured creditors with a fixed charge over specific assets, such as a mortgage with a fixed charge over property
- The liquidator’s fees and any other expenses associated with the liquidation process
- Preferential creditors, including HMRC for VAT and PAYE tax debts, and employee wages and salaries
- Secured creditors with a floating charge over a class of assets, such as stock
- Unsecured creditors like suppliers, landlords and utility companies
- Connected unsecured creditors, including directors, shareholders and family members who have lent the company money
The liquidator must pay all the creditors in each group in full before they can move on to the next. That means the creditors towards the bottom of the list, commonly the unsecured creditors, are often not fully repaid or do not receive any of the money they are owed. Those debts are then effectively written off as part of the liquidation procedure and the creditors cannot recoup their losses.
When can you become personally liable for company debts?
The debts a limited company cannot repay are usually written off when it closes, but there are some instances when the directors can become personally liable.
Providing personal guarantees
If you provide a personal guarantee to a lender, supplier or landlord and the company fails to repay the debt, that creditor can pursue you personally for the outstanding sum.
Having an overdrawn director’s loan account
If you take money out of the company that’s not in the form of a salary or dividend, the liquidator can make you personally liable to repay it.
Trading while insolvent
If you continue trading an insolvent company that has no realistic prospect of returning to profitability, you can become liable for any further losses your creditors incur. Seeking professional advice from an Insolvency Practitioner as soon as you know the company is struggling will help you act in your creditors’ best interests.
Selling company assets at below market value
If you sell company assets for less than they are worth to connected creditors, the liquidator can seek to reverse the transaction. If they cannot, you could become personally liable for the loss.
Engaging in fraudulent trading
If you trade with the deliberate intention of defrauding creditors, such as misrepresenting the company’s financial position to borrow money you know it cannot repay, you can be made personally liable for those losses. The most serious examples of fraudulent trading can even lead to a custodial sentence.
Failing to meet your duties as a director
A director who breaches their legal duties to the company, for example, by mismanaging company funds or making preferential payments to connected creditors, can also be held liable for the losses.
Are my personal assets at risk due to limited company debt?
In most cases, your personal assets are protected by the limited liability you benefit from as a company director. That means creditors cannot pursue you personally for debts the company cannot pay.
However, if you are made personally liable for the debts of an insolvent company, a creditor can pursue you through the courts if you cannot pay what you owe. That can lead to enforcement measures, such as seizing assets and even bankruptcy proceedings.
How can we help?
If you are concerned about what happens to debt when a business closes, consult a licensed Insolvency Practitioner at your earliest opportunity. At UK Liquidators, we can assess your business and guide you through your options. We can also implement formal liquidation procedures to protect your position and deal with company debts properly. Please get in touch for a free consultation or arrange a meeting at one of our 100+ offices throughout the UK.
