Save yourself from financial disaster: Seven real-life SME case studies

There are plenty of sad personal stories behind the latest provisional statistics from the Insolvency and Trustee Service Australia. And plenty of these stories involve former SME owners losing or at serious risk of losing their personal assets, including family homes, from the failure of their businesses.

In 2011-12, nearly 32,000 insolvent debtors either became bankrupt or entered legally binding arrangements with their creditors as an alternative to bankruptcy. And in almost a quarter of the cases, their personal bankruptcy was linked to their business troubles.

Stark statistics provide no insight into the tens of thousands of people indirectly but severely affected by the bankruptcy of a spouse, parent or business partner.

Although only a relatively small percentage of SME owners will ever face bankruptcy, it doesn’t mean that it is smart to ignore asset protection strategies that may help guard your personal wealth if your business were to unexpectedly fail in the future.

Although many SME owners conduct their businesses through limited liability companies or discretionary trusts with corporate trustees, many go bankrupt having given hard-to-avoid personal guarantees to their creditors.

Others are caught in such ways as directors being held personally responsible for unpaid PAYG tax instalments, unpaid superannuation guarantee contributions and debts incurred by their businesses when trading while insolvent.

Tax and asset protection lawyer Ken Schurgott, a director of Schurgott Noolan in Sydney, says the best time for SME owners to implement an asset protection strategy is when their businesses are doing well. This makes it harder for a trustee in bankruptcy to claim under the clawback provisions in the Bankruptcy Act that the strategies were undertaken to avoid creditors.

“The best asset protection plan is the one you never need,” Schurgott emphasises.

Popular asset protection strategies include holding the family home in the name of a low-earning, low-risk spouse; keeping assets in discretionary trusts; making large contributions to superannuation; and having substantial life insurance policies.

Here are seven real-life case studies of SME owners and their efforts to protect their personal wealth:

1. A close shave

Case study: A retailer in a high-rent shopping centre in the Sydney CBD watched in horror as her shop failed following a fall in the numbers of overseas tourists. She feared that her personal assets were at risk as rental arrears spiralled.

Outcome: The failed retailer sought advice from Ken Schurgott of Schurgott Noolan who found to his amazement that she had not signed a personal guarantee with the landlord to secure the rent. In this case, the landlord could not pursue her personally for unpaid rent because she was trading as a limited liability company and had not signed personal guarantees.

Schurgott says the landlord had “desperately” want to have the woman’s shop as a tenant and was therefore willing to forgo its usual demand for a personal guarantee. This escape from the clutches of a personal guarantee is rare in retailing.

Lesson: “Don’t sign a personal guarantee if you can possibility avoid it,” advises Schurgott. “That’s a major way of saving your financial skin.”

2. Double jeopardy

Case study: A married couple arranged for the family discretionary trust to invest in a restaurant run by a brother and sister team. The trust already held listed shares and term deposits.

Sadly, the restaurant did not produce enough income to pay for a costly refit and the business failed. And creditors sought to recover their money.

Outcome: Small business specialist Sue Prestney, a principal with accountants MGI in Melbourne, says although both couples had invested in the restaurant through separate discretionary trusts, the impact of the restaurant’s financial collapse was very different.

The married couple – who sought Prestney’s advice after the business collapsed – were individual trustees of their discretionary trust. The brother and sister team had each invested through their own individual discretionary trusts – each with a corporate trustee, which had no assets other than $12 of issued capital.

Prestney explains that the three trusts were partners in the business and therefore jointly and severally liable for its debts. However, the brother and sister could not be personally pursued for the company’s debits because their trusts had limited liability companies as trustee.

Yet the married couple, as personal trustees of their discretionary trust, were personally held liable for all of the restaurant’s debts. They ended up selling the trust’s assets to avoid bankruptcy. And the tax office took a garnishee on the husband’s salary from his full-time job to pay off the restaurant’s PAYG tax debt.

Lessons: Prestney says the couple should have sought professional advice about the best way to invest in the restaurant. They should have formed a separate trust solely to invest in the restaurant, not using a trust that also held personal investments. And Prestney advises clients to always use a corporate trustee for a discretionary trust when making non-passive investments. (In this case study, the investment was a partnership of trusts and therefore not passive).

“When people go into any reasonably-sized business,” says Prestney, “the first basic thing is to get a limited-liability structure. And for most people that is a standard company. If you are using a trust, you should have a company as trustee, which provides the same protection.

“While [company] directors will be personally liable under specific statutory liabilities, they won’t be liable for general business creditors unless they have given personal guarantees,” she explains.

3. Engineered to fail

Case study: An engineer ran a thriving engineering business that provided a solid income for many years. He was sole director of the operating company and his wife was the sole shareholder. Eventually he decided to retire and his wife sold the shares in the company.

Under the sales agreement, the buyer acquired the solvent business, taking over both its debtors and credits. The buyer recovered the debts as expected but then disappeared without paying its creditors.

As the engineer had signed personal guarantees to pay for debts incurred by the company to the point of sale, the creditors then pursued him for their money.

Outcome: “It was quite horrendous,” recalls Prestney. The engineer was declared bankrupt. And to make matters much worse, the creditors began to make claims against the value of the family home.

His share in the family home had been transferred to his wife six years earlier, long before the sale of the business. However, the creditors used the precedent from a well-known High Court case six years ago involving former Sydney barrister John Cummins and his wife, Mary. (Cummins is also well known for not having lodged a tax return for 45 years.)

In the Cummins case, the High Court looked at circumstances where a husband and wife each contributed to the purchase price of the matrimonial home but the title was in the name of one spouse – in that case, Mary Cummins. And the court found that in such circumstances, it may be “inferred that it was intended that each of the spouses should have a one-half interest in the property, regardless of the amounts contributed by them”.

Prestney explains that the engineer had contributed to the mortgage from his salary and had financed home improvements. She believes it is likely that the couple will have to sell their home to help pay their former business’s debts.

Lessons: Again, there are plenty of lessons from this experience. Prestney says the couple could have sold the assets of the business yet retained the creditors and debtors, which were approximately of equal value at the time of the sale.

Now to the matter of the family home. Following the transfer of the husband’s share in the family home to his spouse, Prestney says the couple would have ideally made sure that all mortgage repayments were made with her money – perhaps using her dividends from the engineering business.

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