There are many good reasons to trade as a company, including a flat income tax rate and more flexible ownership, investment and control structures. However, easily the most compelling reason for incorporation is the ‘shield’ the company provides to separate the owners (usually asset holding individuals) from the risk bearing trading activities.
It therefore surprises us when we see directors of ‘Pty Ltd’ businesses unnecessarily exposing themselves to personal liability. On the ‘flip side’, we regularly hear experienced business owners overlooking the difference between a company obligation and the obligations of those behind it.
The most common method for getting around the corporate shield is the personal guarantee. Individuals, including directors, should always try to avoid signing these documents because it exposes the guarantor to the company’s trading liabilities, which is among the best reasons for using a company to trade in the first place. Having said that, in practice it will often be impossible to obtain bank or trade credit without giving a guarantee.
As a creditor, you should always obtain a personal guarantee unless you are doing business with a large and reputable company (like Ansett, One.Tel, HIH Insurance?). Directors are often reluctant to give one. Ask them: “If you are not confident enough in your company’s ability to honour its obligations to be personally liable for them then why should I provide goods or services on credit to it?”
There are a myriad of arguments that may be raised to avoid liability under a poorly worded (or incorrectly completed) guarantee. Ellem Warren Lawyers have assisted many directors to escape liability under guarantees because of confused cross-referencing, terms incorrectly defined or the use of inconsistent company names or ACNs. We recommend guarantee documents be prepared, and regularly reviewed, by an experienced lawyer.
Directors are exposed to the company’s tax liabilities in some (not all) instances, including as follows:
- The directors are exposed if the company fails to remit PAYG withholding tax or superannuation and does not report or pay it within 3 months of the due date for lodgement. It is no longer enough to wait in safety for the issuing of a director penalty notice. Defences are potentially available but only in very limited circumstances.
- Directors will be exposed if the company enters into, and breaches, a repayment agreement made with the ATO under s.222ALA of the Income Tax Assessment Act 1936.
The ATO is easily the most frequent creditor in company liquidations, and is often the largest, and the last 18 months have been one of the most active periods of ATO enforcement that we have ever seen.
Directors have a duty to prevent a company from insolvent trading. Insolvent trading occurs when a company incurs a debt that it cannot (and does not) pay, at a time when the director knew or should have known that the company was insolvent. The director may become liable to pay compensation equal to the amount of these unpaid debts.
Directors may be able to successfully defend an insolvent trading claim if they can establish one of the following: (a) they had reasonable grounds to expect (and actually expected) that the company was solvent; (b) they did not participate in management because of illness or some other good reason; or (c) they took all reasonable steps to prevent the company from incurring the debt. These defences are more difficult to make out than they may appear. The courts expect all directors to very closely supervise company operations.
The above examples are, in my experience, the most common causes for directors becoming personally liable for company debts but this article is not intended to be exhaustive. If you are a director, and ever become concerned about solvency issues, do yourself a favour and promptly consult with a solicitor with suitable expertise.