Running almost any business carries risk. Covid taught us that even the most solid business can be struck down by unforeseen threats. Often, the failure of a business can lead to the business owner losing everything. However, there are ways of minimising those risks.
Using a company structure
Historically, the reason companies came into existence was to protect investors from personal liability should the enterprise fail. Without that protection, investors would not be prepared to take the risks necessary to establish businesses which support our economy.
Still today, directors are not liable for the debts of a company which goes broke, subject to certain limited exceptions referred to below. Running a business through a company is still the best protection from personal liability from the effects of the business failing. This applies whether the company runs the business, or is the trustee of a trust running the business.
Sometimes, directors agree personally to guarantee a specific obligation of a company. Many standard agreements I telephone contracts or leases of photocopiers contain standard directors’ guarantees. If so, of course, the directors can be required to pay the debt if the company becomes insolvent.
Directors also have a duty to act reasonably in managing their companies, and a duty not to allow the company to incur debts without a reasonable expectation that they can be paid. Provided the directors comply with these requirements, they are not personally liable to any of the ordinary creditors of the company.
Avoiding personal liability for tax debts
Directors can be personally liable for failing to send the ATO the PAYG deductions they have taken from their employees’ wages. They can also be personally liable for superannuation and GST. However, this only applies if they failed to lodge BAS returns within 3 months of the due date, or if the ATO sends them a directors penalty notice (DPN) with which they do not comply. Complying with a DPN requires the director to arrange to pay the tax debt or put the company into administration or liquidation. Provided the director does so, there is no personal liability.
There is a widespread myth that the Tax Office has special privileges in liquidation of a company. Historically, that was true but it is no longer the case. The ATO is just like any other creditor of a company in liquidation.
The law that allows liquidators to claw back all money paid by company to the ATO within 6 months before the commencement of the winding up, and provides that the directors then to be liable to the ATO for that money. It does not apply if the ATO can show that it had no idea that the company was insolvent when you receive the money. However, this is rare. This strange law an incentive to directors of insolvent companies not to pay company tax.
In summary, if the directors make sure that BAS returns are lodged within a reasonable period, and comply with the requirements of any DPN they receive, and don’t pay tax while the company is insolvent, they have no personal liability for tax.
Beware of the pitfalls
Often, directors of a company running a small business don’t take regular salaries, especially if the company has tax flow issues. Instead, they take whatever money is available from the company, and leave it to the accountant to record it properly after the end of the financial year. That is very dangerous. If money is taken from the company without being properly recorded as wages or directors fees, and the company goes into liquidation, the liquidator will claim that money back from the directors personally.
The solution is that any money the directors take from the company should be properly recorded in the books of the company as soon as possible.
A useful tip
Many small companies are funded by moneys provided by the directors. If so, these loans should be recorded in a formal loan agreement, which should be registered in the Personal Property Security Register as a charge over the company. We do this for many of our clients.
If the business fails, and the company ends up in liquidation, the secured loans to directors will have priority over unsecured creditors. It gives the directors some control over the liquidation process. However, the registration must take place at least 6 months before the commencement of the winding up, otherwise the charge is invalid against the liquidator. It is a good idea to register the charge without delay. By the time the company may be facing insolvency, it could be too late.
For more information contact Tim Somerville or Andrew Somerville on (02) 9923 2321.
