Most people in business have heard or been told that by having a company to conduct business, their personal assets are protected. A fewer number of those in business have heard or been told that a trust can also protect their personal assets.
As a general rule, both propositions are true. But, there are (regrettably) exceptions to most rules. Exceptions exist that overcome these general rules.
However, there are exceptions to the general rule that the assets and liabilities of a company and/or trust are not the personal responsibility of the director or trustee.
These exceptions can be seen in the following two diagrams.
Figure 1 - Exceptions for Directors
Figure 2- Exceptions for Trustees and Beneficiaries
The two main exceptions are when a person is asked to give and gives a personal guarantee and statutory exceptions.
(There are other more technical exceptions. Those that attended the Business Alliance NSW seminar with me on 17 September 2020 will have heard about them. Those that missed out and are interested can ask for a copy of a paper I wrote for a technical seminar I gave to lawyers in 2019. Email me at email@example.com if you want a copy for either you edification or as a cure for insomnia.)
1. Providing Personal Guarantees.
A personal guarantee is usually given to a creditor (e.g. a creditor or lessor) by a director who is also a shareholder of a company as additional security for the company's borrowings. Personal guarantees are usually required for start-up companies that do not have a credit record.
A guarantor must make sure that they are comfortable with the amount that they guarantee. Suppose the company defaults on the payment of the loan. In that case, the creditor will demand payment under the guarantee, and if the guarantor cannot pay the creditor can seek a bankruptcy order against the guarantor. The creditor can ultimately force the personal guarantor to sell any of their assets which they own to pay the amount owed.
In summary, the disadvantages of a personal guarantee include:
The burden of a personal guarantee stays with the person giving the guarantee (e.g. director, shareholder, trustee or beneficiary). It does not affect the assets of the company or trust. The creditor can demand payment from the person giving the guarantee, rather than from the primary borrower.
A guarantee is usually given on a full indemnity basis. A full indemnity basis is where the creditor to get payment has only to prove that the company or trust owes the money and that the loan repayments have not been made.
Until the creditor recovers the money owed by the company in full, the person giving the personal guarantee remains liable in full.
By providing a personal guarantee, your personal property and assets are directly exposed should the company not meet the guaranteed payments.
Providing personal guarantees is a voluntary means by which directors enter into transactions that expose their personal assets.
2. Personal Obligations Imposed by Statute
The general proposition is that directors are not personally liable for the debts of the company for whom they act as a director. The principle of limited liability in company law has never been seriously challenged. The legislature has nonetheless recognised some circumstances in which the protection will not be available.
The legislature has enacted many statutes that impose a personal obligation on directors for the debts of a company. Examples are under ss 588G - 588U of the Corporations Act 2001 (Cth). Directors of an insolvent company who fail to prevent it incurring a debt may be made personally liable to pay the debt. Another example is penalty notices issued under s222AOE of the Income Tax Assessment Act (Cth) 1936.
Once a penalty notice is issued the personal liability is fixed. There is no longer any way to relieve yourself of the debt.
Similar forms of penalty notice arise from State Revenue liabilities such as payroll tax.
Limit personal guarantees: directors and trustees should avoid giving guarantees as far as possible. Where it is not possible to avoid giving guarantees, there may be potential to negotiate a cap on the extent of liability or a time limit to the liability.
Limit directorships: many businesses have only one key person. Still, they have two or more directors, as was required before 1998. The additional directors may be unnecessary, and if so, they should resign their directorship, which may remove them from further exposure from their guarantee and other directorship-related liabilities.
Limit director ownership of assets: a director with few assets in his/her name is not an attractive target for a company liquidator to pursue if the company goes into liquidation.
Consider having your personal assets in a trust.
Avoid insolvent trading: all directors will be personally liable to company creditors for company debts incurred while the company is allowed to trade while insolvent. Significant criminal sanctions may also apply.
Be aware of director duties: directors have numerous responsibilities under common law and various statutes. Being aware of these duties, performing them adequately and ensuring the company meets its tax, trade practices, and other obligations can reduce personal liability risk.
Consider loans and other personal transactions with the company: a liquidator can void certain transactions with a company by a director or related entity of the company (including directors' relatives) where they are favourable to the director or related entity.
If in any doubt get advice.