Sole Proprietorship Bankruptcy

Director Liability on Small Business

Dear Colleen,

I am planning to set up a business. Deciding the business structure, sole proprietor, limited company, what is the best structure for small business.? What happens in a sole proprietorship bankruptcy?  If I choose limited liability structure or any other structure and maybe in future the business is not very successful and the business declares bankruptcy? Does it mean that I am personally automatically bankrupt? Can a sole proprietorship declare bankruptcy?

Answer:  Concerns for Small Business Start-Up?  Should you be a sole-proprietor or start a limited corporation?  Is Director Liability different for both? What happens in a sole proprietorship bankruptcy?

If you are just starting out in business, it can be confusing as to what is your best option between a sole-proprietor or start your own limited company.

As a person, you are distinct from a limited company even if you are the only shareholder and only Director.  So, if your limited company declared bankruptcy, you would not automatically also be personally bankrupt (a legal state). But you may be held personally responsible for some portion of the corporate debts.  This depends on what kinds of debts that they are and what, if any, guarantees that you have signed.

The intent behind a limited corporation (Ltd.) is to limit the potential exposure of the Directors to liabilities.  So, if someone (like an unhappy customer) were to sue the company, then you as a Director would not automatically be personally responsible.  The “corporate veil” as it were, should keep you and the company separate.  But this veil is not perfect, and creditors are always trying to pierce this veil to get at the Directors personally.  This can be done by agreement (i.e. you agree to be personally responsible otherwise the creditor will not give the company the loan/debt). Or by legislation, like CRA (Canada Revenue Agency) who have successfully amended the Canadian Tax rules to make Directors personally responsible for certain types of debt.

What is Director Liability for a Small Corporation?

The types of debts that will follow you as a Director (Director’s Liability) include such things as:
GST,

payroll tax,

employee wages, etc.

even if you have not agreed to pay them.  It is an automatic thing.

Other debts end up being your responsibility as your creditors, like a bank etc., will ask for your “personal guarantee”.  A personal guarantee means that if the company does not pay the debts back, that you as a Director would be held personally responsible for the debts.  Most banks ask for personal guarantees on General Security Agreements.

Also, as an entrepreneur, you may be tempted (or indeed be forced) to use your personal credit sources, (like Lines of Credit, or credit cards) as seed money to float your new business venture.  This is quite common in small or start up businesses.  If your personal name is on the statement/card, then you are personally responsible.

Why set up a limited corporation?

There are certain benefits to having a limited corporation, but there are also significant costs (like increased accounting and legal fees,) and complications.

Some people think that if they set up a limited company, it will mean that they can write off more expenses vs. being a sole-prop.  This is not true.  In Canada you can write off business expenses on your personal tax return.  You can write-off the same expenses that you would have been able to deduct if you had a limited company.

Others believe that you will pay less taxes if you have a limited company.  This is also not completely true.  It is  true that the “corporate” tax rate is less than what it may be personally, but that is only true if money is left in the company.   i.e. not in your bank account.  There are some accounting issues with moving funds between a person (shareholder) and a company.  However, the tax system is set up so once the funds end up in your hands personally, the tax rate is virtually the same. (currently, 2018, it is withing 1%).

I would estimate that 30% to 40% of the people that I see are self-employed and many have limited companies.  Unfortunately, they may be very good at what they do for a living, but many find the bookkeeping and tax filings to be overwhelming and confusing and frankly, the last things on their minds when starting up a new business venture.  And having a limited company just adds one more layer of accounting/tax complying or filings that get left behind.  Once things get behind, it can be difficult to get back on track for many entrepreneurs.

Before deciding on which alternative works best for you, it would be best to talk to both your accountant and your legal counsel.  I would be happy to recommend local professionals if you are looking for this type of advice.

Other related topics in this area

Limited Company Bankruptcy, What is Director Personal Liability

 

sole proprietor or limited company, what is best for start up?

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