A Director’s Quick Guide to Insolvent Trading

Regardless of economic conditions, insolvency can impact businesses both in prosperous times and during economic downturns.  If you’re a director of an Australian company, it’s your duty to make sure the company stays financially healthy and meets its financial commitments on time.

When navigating the complexities of insolvency, seeking personalised advice is crucial. At Blackwattle Tax, we advise initiating a conversation with your accountant prior to reaching out to a liquidator. While there are reputable insolvency practitioners, it’s essential to note that their focus often lies in promoting liquidations. 

If your goal is to steer clear of liquidation, a prudent first step is consulting with a qualified tax agent. Professional Chartered Accountants or Registered Tax Agents are well-versed in negotiating with the Australian Taxation Office (ATO) and adept at handling insolvency scenarios.

Think of it like seeking advice from a mechanic rather than a car dealer to explore all your options for addressing the issue effectively.  The mechanic would see all makes and models with a variety of situations, versus a car dealer who only has knowledge of one brand and is only interested in selling you a new car (not help you identify and fix the problem of your existing car).

In this post, we’ll cover the basics of insolvency, explaining how it affects businesses and the important role directors play. We’ll also outline key options and actions you need to think about.

What is considered insolvent trading?

A company is insolvent if it is unable to pay all its debts when they fall due. The company’s ability to pay its debts is assessed by the actual circumstances of the company and predominantly involves applying a cash flow test.

Insolvent trading occurs when a company continues its operations, amassing debts without possessing sufficient assets to meet its financial obligations.

Who is liable for insolvent trading?

Under the Corporations Act 2001, directors are legally obligated to prevent trading while insolvent. This duty places the responsibility on directors to ensure the company’s solvency and take swift action if there are indications of insolvency, serving as a critical benchmark for assessing accountability for subsequent debts incurred after a specified point of insolvency.

The Australian Securities & Investments Commission (ASIC) is the government agency overseeing the registration, operation, and insolvency events for all companies.

Neglecting financial obligations, including tax liabilities, payments to suppliers and employees, and falling behind on superannuation dues, not only presents a significant managerial challenge but also carries the risk of business closure, potential criminal charges, and associated penalties.

What are the responsibilities of directors in insolvency?

In insolvency, directors have specific responsibilities, including:

  • Be Informed: Directors must carefully and diligently exercise their powers, ensuring they are well-informed about the company’s financial situation. Simply claiming ignorance about the company’s poor financial state is not a defence. Being aware of the financial position cannot be delegated to external accountants or advisers.
  • Act in the Company’s Best Interests: Directors are obligated to act in good faith, always prioritising the best interests of the company.
  • Avoid Conflicts: Directors should not misuse their position for personal gain or to harm the company or its shareholders.
  • Handle Information Ethically: Information obtained through their position should not be improperly used for personal advantage or to harm the company or its shareholders.

If a director is found to have recklessly or dishonestly breached these duties, it can lead to both criminal charges and civil claims.

How do you know if you are trading insolvent?

You should keep an eye out for the following indicators that may suggest you are trading while insolvent. While this list is not exhaustive, it’s essential to consult a qualified accountant or insolvency practitioner to thoroughly assess your business situation.

  • Poor Cash Flow: Struggling to maintain a healthy flow of cash.
  • Ongoing Trading Losses: Consistent losses in your trading activities.
  • Limited/No Cash Availability: Lack or restricted access to cash or bank funds.
  • Disorganised Accounting Records: Records that are incomplete or in disarray.
  • Increasing Debts: Liabilities surpassing assets.
  • Unrecoverable Loans: Loans to associated parties that cannot be recovered.
  • Delayed Creditor Payments: Payment delays beyond usual terms.
  • Overdue Taxes: Outstanding tax and superannuation liabilities.
  • Legal Demands: Receipt of debt collection notices and legal demands for unpaid debts.
  • Loan and Capital Challenges: Difficulty securing loans, raising capital, or facing defaults.
  • Internal Disputes: Board disputes and loss of key management personnel.
  • Overdraft Limits: Reaching overdraft limits or defaulting on finance and interest payments.
  • Business Relies on Next Job: Operating under the hope that the next job will salvage the business.

What are the penalties for directors trading insolvent?

Understanding the penalties for directors engaged in insolvent trading is crucial, and these consequences include:

  • Civil Penalties: Directors may face pecuniary penalties of up to $200,000 as part of civil proceedings.
  • Compensation Proceedings: ASIC, a liquidator, or a creditor can initiate compensation proceedings against a director personally, seeking recovery for amounts lost by creditors. This compensation order, in addition to civil penalties, has the potential to be unlimited and could result in the personal bankruptcy of directors. Personal bankruptcy disqualifies a director from continuing or managing a company.
  • Criminal Charges: Criminal charges may be levied, especially if dishonesty is a factor, leading to fines of up to 2,000 penalty units or imprisonment for up to five years. Conviction of the criminal offence may also result in director disqualification.

While the Corporations Act offers some statutory defences for directors, relying on these may prove challenging if steps haven’t been taken to stay informed about the company’s financial position.

The best course of action for directors is to stay well-informed about all operational and financial aspects of the business. This not only ensures prompt and informed action when needed but also facilitates sound decision-making for running a profitable business.

How can I avoid insolvent trading?

The key to stay out of financial trouble is to have up to date and timely management accounting records.  You should also make sure that all ATO tax lodgements are up to date and made on time.  This will ensure that you as a director have an accurate and true picture of the company’s financial performance and position.

If you ever find yourself in a position where your accounts are overdue and not up to date, spend the time and the money to bring them up to date.  The comparatively small cost to do so will save you money in the long run as you can make better decisions on how to navigate an insolvency process.  This means that speaking with your registered Tax Agent and qualified Chartered Accountant should be your first action.

Navigating Insolvent Trading: A Director's Step-by-Step Guide

Step 1 – Bring your accounts up to date

There is a reason why we are repeating this point.  It is because it is crucial for so many reasons.  Updating your management accounts and lodging all tax returns and Business Activity Statements (BAS) will:

  • Ensure you make informed decisions on accurate figures.  There is no point following a certain restricting strategy such as a voluntary administration if the debts are so great that the company would never be able to manage them.
  • Lodging BAS returns on time will mitigate the risk of being issued with a Director Penalty Notice (DPN).  A DPN can hold a director personally liable for the company’s tax debts including PAYG, superannuation and GST.
  • Poor records will mean external advisers such as qualified Chartered Accountants or liquidators will have little ability to provide meaningful advice beyond recommending a liquidation.  This may not be the best option for the company and the director(s), and may in fact be more costly in the long run.
  • External financiers or potential third party funders will not advance funds to a business without up to date accounts, no matter how dire the financial situation.  There are some lenders that actively lend to businesses that need financial assistance.  Note, we highly recommend that you speak with an independent adviser before agreeing to any of these funding arrangements as they may have unintended or unforeseen consequences.

It is helpful for small business owners to understand how the ATO thinks when dealing with company taxpayers.  The ideal taxpayer for the ATO is someone that lodges and pays on time.  For the ATO, these are seen as ‘good behaviours.’  When a company does this, the ATO is happy and the risk of tax audit or review, and enforcement action against the company are low.

The opposite is also true for businesses that have significant overdue liabilities and lodgements.  Companies that do not lodge or pay on time are seen as ‘bad behaviours.’  We recommend the following basic strategy to keep the ATO on side:

  1. Lodge and pay tax returns and BAS on time
  2. If you cannot lodge and pay on time, lodge on time and pay as much as you can without causing significant financial detriment to the business
  3. For the amount(s) that cannot be paid on time, establish a payment arrangement (see below)
  4. Stay up to date with future lodgements and liability payment.  Failure to do so will result in the payment arrangement defaulting.
  5. And above all of these points, communicate with the ATO as much as is reasonably required.  The ATO is willing to work with you if you speak with them.  It is seen as bad behaviour to avoid speaking with the ATO and not respond to calls, notices or requests.  This will inevitably catch up with the company and place the business at a higher risk of tax audit.  The ATO will also be more reluctant to offer assistance to you.

Step 2 – Operational improvements and external funding options

While you are working to bring your accounts up to date, you should also look at operational improvements and explore ways to raise working capital.  Here are some suggested actions you can look at to improve cash flow and increase working capital:

  • Speak with your bank or commercial broker regarding options available to provide working capital
  • Explore options to raise capital from existing or new shareholders
  • Speak with trade creditors and suppliers to extend trading terms.  This will push out the due date for liabilities to improve cash flow
  • Chase outstanding trade debtors and monies owed to the company to bring forward working capital
  • Assess what cost cutting measures can be made to preserve cash flow including making excess staff resources redundant
  • Exit leases early or sub-lease no essential equipment or trading premises (with lessor’s approval)
  • Sell non-essential assets such as idle equipment
  • Identify sales strategies to generate positive cash flow and work down excessive inventory levels.

Step 3 – Establish payment plans

Payment plans are a common tool for small businesses to implement.  They are often used with the ATO and other government organisations to establish a recurring payment arrangement to allow the company to pay the debt in full over an extended period of time.  This helps the company preserve cash flow and have more control / predictability over their working capital requirements.

Payment arrangements with the ATO are also important as they can mitigate the risk of the ATO taking further enforcement action against the company or the director(s) personally. 

It is also not unusual for a company to establish these arrangements with trade creditors as it is often preferred to the common alternative of a liquidation.

Step 4 – Small Business Restructuring Plan

Sometimes, directors can do everything right but still find themselves in a position that leaves them with few options to resolve the financial position of the business. In these cases, we suggest exploring whether a Small Business Restructuring Plan (SBRP) can apply.  It is a useful process that helps small business restructure unsustainable levels of debt via a proposal that is put to creditors to approve.  If approved, it allows the business to continue trading without the significant detrimental impacts of a liquidation. 

The SBRP process is put forward as an alternative to liquidation and is designed to provide a better outcome for creditors, employees, the company and business owners compared to a traditional liquidation. 

To be eligible for the SBRP process, a company must meet the following criteria:

  • company is insolvent or about to become insolvent
  • company’s total liabilities are less than $1 million (excluding accrued employee entitlements)
  • No directors have been a director of another company that has gone through a Small Business Restructuring or a Simplified Liquidation process within the last seven (7) years
  • company is up to date with its tax lodgements and all employee entitlements (excluding leave and other entitlements not currently due to be paid).

There are three (3) key phases to a SBRP process:

  1. Pre-appointment: bring the company’s accounts up to date and ensure all outstanding tax lodgements are completed.  The company meets with the small business practitioner to understand the process, the eligibility and the implications for stakeholders
  2. Restructuring: a restructuring plan is prepared by the company (often with the support of the external accountant).  The plan is submitted to creditors, who then have 15 days to vote on the plan.  If creditors approve the plan, the terms of the restructure commence.  If the plan is not approved, nothing happens and the company must think of an alternative action
  3. Plan: the company adheres to the terms of the plan which can go for as long as three (3) years.  The plan may be a one-off contribution into a fund to be distributed to creditors or may be some other periodic payment arrangement.  The company continues to trade as normal during the plan and control of the business remains with the directors.

It is important to align yourself with a qualified Chartered Accountant and Registered Tax Agent that has experience through these complex situations.  This will ensure that you are receiving independent advice focused on providing you as a director and the company the best outcomes.


Ready to consult with qualified tax agents at Blackwattle Tax on how to prevent insolvent trading?

Navigating financial distress in your business can be incredibly stressful, and taking proactive steps is crucial. The worst thing you can do is nothing and bury your head in the sand. Don’t wait for external pressure—reach out to Blackwattle Tax for a personalised assessment of your options and proactive support.

Book a FREE 30-minute consultation today to discover how we can help you prevent insolvent trading and secure the future of your business. 

At Blackwattle Tax, our seasoned team of Chartered Accountants and tax agents is prepared to assist businesses in a range of industries. With a track record of supporting diverse sectors, including Property & Construction, Retail & Hospitality, Food & Beverage, E-commerce, Healthcare, Transport, and Professional Services, we empower clients to make informed decisions, ultimately resulting in enhanced financial and tax outcomes.

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Disclaimer: We endeavour to make sure the information provided in this guidance is up to date and accurate.  Please note, that the information is only intended to be a guide, with a general overview of information.  This guidance is not a comprehensive document and should not be interpreted as legal advice or tax advice. The information is general in nature.  You should seek the assistance of a professional opinion for any legal and tax issues related to your personal circumstances.