One of the most attractive features of being a sole trader is the freedom, flexibility and low set up and administration costs. However, one of the biggest disadvantages is the personal liability which comes with running an unincorporated business.
This article discusses this personal liability and how you may further protect yourself by forming a company.
What is the liability profile of a sole trader?
The liability of sole traders is unlimited. As a sole trader, you are the business and this means that any business expenses, debts, loans or other liabilities belong to you and not the business. If you cannot satisfy a debt, the creditor could sue you personally to recover the debt and, if successful, the creditor may be able to access your personal assets, such as the family home.
Moreover, many loans provided by banks and other lenders to sole traders are often secured by the sole trader’s personal assets. These personal assets often include the family home, which means that the bank could force the sale of your home to repay the loan.
What is the liability profile of a director of a company?
On the other hand, a company is an independent legal entity, separate from its directors, shareholders and employees. The company’s assets and liabilities belong to it. As such, one of the advantages of operating a company is the restriction regarding liability of shareholders and directors.
Shareholders have limited liability; they are not responsible for the company’s debt and usually, the most they would be liable for would for would be the unpaid amount on any shares.
Directors are generally free from personal liability for the company’s debts, but can be liable in a number of different scenarios, for example where that director:
- signs a personal guarantee;
- commits an act of fraud or negligence or other civil or criminal laws; and
- breaches their duties as a director (including running the company whilst the business is insolvent).
When would personal guarantees be required of a director?
Personal guarantees are sometimes required of directors, especially when the company is small and has a short track record. Personal guarantees are often required in the context of a company opening or extending a credit facility or enterinto into a lease agreement. This guarantee means that the director will need to meet the debt owed to the creditor if the company is unable to meets its obligations.
The upshot of this is that simply forming a company will not absolve a director of personal liability or the financial responsibilities of running a business.
The question of liability is an important factor to consider in determining the best structure for your business. There are a number of advantages and disadvantages to operating as a sole trader or forming a company, but if you plan to grow your business, you may wish to benefit from the limited liability of a company structure. However, as noted above, a director will still not be completely absolved of personal liability and it is therefore critical for a director to keep up-to-date on the financial position and performance of the company and make informed decisions accordingly.
We are able to give you specific advice, tailored to your circumstances, on the most suitable structure for your business.