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In our experience dealing with financial problems connected to both personal and company debt, there can be some misunderstandings about the difference and connection between these two areas.
For company directors, financial challenges can be particularly stressful, as their personal finances and business obligations are often closely intertwined. Understanding how personal and company debts interact is crucial in preventing financial difficulties from escalating into insolvency or bankruptcy. Most importantly it's vital you know the difference between the two areas and how one can influence the other.
The financial relationship between the business and you as the owner depends on its legal structure. The most common business structures are:
A limited company which is a separate legal entity from its directors. That means the business’s debts are not usually the personal responsibility of its directors. However, as a director, you can still face financial consequences in certain situations.
Partnerships are common in some sectors. All partners are personally liable for the business debts. However, limited liability partnerships (LLPs) offer some protection.
Sole traders, which are very common, have no legal separation between personal and business finances. As a result, any business debts are the sole trader’s personal responsibility.
While there are some other possible business structures they tend to have a very specialist reason and are often third sector based. However, from the point of view of the leadership they will fall into one of two groups. Either the owner/trustees or similar will be personally legally responsible for the financial position or the business/charity will be a legal entity in its own right.
In theory, if you are a company director, the independent legal status of the business should mean you are protected from personal issues if the company becomes insolvent. For the most part, this is true, but life is rarely cut and dried and this area is no different. There are several points where personal and business concerns can come together to affect your financial and personal wellbeing.
One of the biggest financial risks for directors of limited companies is signing a personal guarantee for business loans, leases, or supplier contracts. These are often required to raise the funds needed to start a business or expand it, as well as for leases and some supplier contracts. A personal guarantee literally means that if the business cannot repay the debt, the director becomes personally liable.
In practice then, if you do sign a personal guarantee, and the business becomes insolvent, you are agreeing to ensure the debt is paid. That could include using your home, savings and other assets to raise the money.
Personal guarantees are just one area where business financial issues can directly impact your personal financial wellbeing and, in extreme cases, result in personal bankruptcy. You should be very wary of using personal guarantees for the wrong reasons. Using them to obtain a loan because cash flow is tight for example should be a red flag unless it is clearly due to a temporary issue. Before you make that decision, you need to take a dispassionate look at the situation. Undue optimism has caused many a director to later regret a decision to shore up a failing company.
Many directors of limited companies take a small salary and supplement their income with dividends. However, you must make a profit or have reserves to pay these dividends from, and we regularly see cases where they have been paid when the money simply wasn’t available to do so. Paying dividends when the company is not profitable or lacks sufficient retained earnings is a very risky move financially, and, more importantly, it is likely to be illegal.
It is vital that directors remember that dividends can only be paid from profits or retained reserves, not from loans, reserves, or even capital meant for company operations. That will include funds obtained for a bounce back loan. Should you need to prove the use of these funds and that included director’s dividends, you find yourself in some pretty hot water.
The consequences of mispaid dividends can be significant and personal. Directors who received mispaid dividends may be ordered to repay them, and the limited status of the company will not protect you.
A director’s loan account (DLA) is money taken from the company by a director that isn’t a salary, dividend, or expenses and it is very common for directors to take these supposedly short-term loans. DLAs can become problematic though if the business becomes then becomes insolvent. Sadly, many directors take loans from their business when cash flow is tight intending to repay them when profits improve. It is also common that they have taken dividends for which the Company doesn’t have reserves and the Company Accountant will sometimes post these sums to the director's loan account. If the business fails, that DLA money is still outstanding. So, the bottom line is that if the company becomes insolvent, a director’s loan becomes a debt owed to the business. In this case, the money is owed by the director and becomes a personal debt.
When a company becomes insolvent there is usually also an amount of personal stress to deal with. In fact, dealing with business financial problems can have a severe impact on a director’s mental health. Many will feel a personal responsibility for their employees, creditors, and customers, which can lead to anxiety, depression, and burnout when financial struggles arise.
Avoiding the problem or burying your head in the sand about your business finances is common, but it usually only worsens the stress. Many directors delay seeking help, both on personal and business matters, due to fear, pride, or a belief that they can turn things around themselves. However, avoiding financial problems often makes them worse. Financial stress can also spill into personal relationships, causing strain on families, friendships, and overall well-being.
If a business is struggling with significant debt, consulting an insolvency practitioner (IP) like Smart Business Recovery early on can provide options before things become unmanageable. While this may not guarantee you won’t struggle with the stress of the situation personally, taking action will certainly help put you back in control.
Speaking to one of the personal debt services such as StepChange for support is also a good course of action if your personal financial situation looks difficult. We all want you to get to the end of this process with the best possible result. If that means personal bankruptcy, then we can help, but you should explore all other options first.