Common pitfalls for insolvent clients: what accountants need to know
When a business edges toward insolvency, routine decisions can quickly become high stakes. As trusted advisers, accountants often spot the warning signs first, and early guidance can make a significant difference. This overview highlights the key risks your clients may face.
Dividends and directors’ loan accounts (DLA)
Many owner-managers draw funds through their loan accounts and clear the balance with a year-end dividend. This works only if the company has sufficient distributable reserves. Once insolvency looms, and distributable reserves dwindle, this strategy becomes unviable.
It is common to see companies enter liquidation or administration with sizeable overdrawn DLAs, leaving the insolvency practitioner (IP) with no option but to seek repayment from the directors. When solvency is in doubt, directors should switch to a fair, justifiable salary to stop the overdrawn DLA worsening.
Preferences
Similarly, repaying a DLA to a director prior to an insolvency process can create issues. Payments to a director, or to any creditor they have reason to prefer, may be challenged as a preference. The result can be repayment demands on the recipient and personal liability for directors for allowing the payments.
Transactions at undervalue
Asset sales must reflect fair value. Underselling equipment, stock or other assets (particularly to connected parties) is a common misstep. If value is lost, the IP can potentially unwind the transaction and pursue recovery from both the buyer and directors.
Redundancy Payments Service (RPS) issues
Employees, including directors with genuine employment status, are entitled to certain statutory payments through the RPS for such things as redundancy and arrears of wages.
However, the RPS will offset any award to directors against an overdrawn DLA. It often rejects director claims altogether due to lacking formal employment contracts, or salaries so low they fall beneath minimum wage thresholds when measured against actual working hours. That can leave directors without support at a time when their personal position is also vulnerable.
Directors should consider having a formal employment contract in place and ensure they are paid minimum wage in accordance with it, to minimise this risk.
Shift in directors’ duties
Once the directors know, or ought to know, that their company is bordering insolvency and an insolvency process is probable or unavoidable, they must focus on protecting creditors’ interests. Continuing to trade while increasing liabilities can give rise to wrongful trading claims by the IP against the directors. With the right advice, directors can often defend or avert such claims by showing they took every step to minimise losses.
Successor businesses
Confusion between personal and company assets can cause trouble in distress situations, particularly when setting up a successor business. Transferring any assets for less than they are worth into a new vehicle can be attacked as a transaction at undervalue by the IP.
There are also restrictions on reusing a company name similar to one that has failed. Failing to adhere to these can mean personal civil and even criminal liability for the directors.
However, there are certain exceptions which can be used, such as prior existence of the successor company, a court application or proper notice in the Gazette.
Why early advice matters
These pitfalls share a common thread: they can create personal exposure for directors. An IP acting as liquidator or administrator is required to recover value for creditors, and director conduct is often central to that process. Early, well-informed advice is the most effective safeguard.
Here to help
If you or your clients are navigating financial distress, contact our experienced restructuring and insolvency team at Moore Kingston Smith. We work closely with accountants and advisers to support clients where insolvency risks emerge, helping to address issues early, minimise exposure and work towards practical solutions.
