Understanding Liquidation; Solvent and Insolvent
Many people hear the word liquidation and automatically think it is a negative process for businesses that are in trouble and suffering from insolvency through the fault of the directors.
This article is going to explain the different reasons as to why insolvency occurs and highlight just how helpful a liquidation process can be for both an insolvent and solvent company.
How can insolvency occur?
There are many reasons as to why insolvency occurs within a limited company. Putting aside the reasons that would come under director misconduct, below is a list of 5 other reasons as to why a company may become insolvent:
- Receiving late payments themselves from customers
- A company they have been dealing with has entered a formal insolvency process which has had a knock-on effect
- A dip in their market place means sales are low
- Increase in competition
- Incorrect pricing on goods
These unfortunate incidents can impact negatively on a trading company which ultimately can result in that company having to deal with insolvency and entering a liquidation process; if there are no alternatives available. Entering into a voluntary liquidation process means the directors are trying to minimise the risk to creditors, which in an insolvent situation is the correct thing to do.
Why choose a Liquidation Process?
Whether a company is struggling with insolvency or is in fact, just looking for a way to close down their solvent business effectively, there is a liquidation process to suit.
For an insolvent company many directors may think that they can trade out of their troubles or just stop trading with the hope of no one noticing, but choosing a liquidation process will ensure all loose ends are tied up and will ensure a clean break for all directors involved with no angry creditor chasing after the money that they are owed.
What is a Solvent Liquidation?
The term solvent means that a company’s assets must exceed their liabilities and that they are able to pay all of their creditors in full within 12 months including statutory interest.
A Members Voluntary Liquidation (MVL) is the formal liquidation process which is used to close down the affairs of a solvent company. The alternative process that is an informal option is called a Strike Off.
Since changes to the legislation in 2012, in order for final shareholder distribution of funds that exceed £25,000 to receive automatic capital tax treatment (this is where distributions are classed as capital receipts rather than income) an MVL process will need to be used. This system replaces the former HMRC concession known as ESC-C16 which would have previously been used in order to receive the tax benefits.
These tax benefits are the main reason companies use an MVL process. There is also the possibility of receiving the tax treatment known as Entrepreneurs’ Relief. If this relief is available to the funds then it can reduce the tax rate down to a low 10%. This saving therefore usually outweighs the cost of the liquidation process itself.
The actual process is also deemed to be a huge benefit to the directors as it provides the chance to dissolve a company in the correct way and not leave any unattended issues behind. The process can also be seen as a benefit to the accountant as it would provide further chargeable hours of work for them in order to prepare the accounts needed in this process.
What is an Insolvent Liquidation?
The term insolvent means that a company cannot pay their creditors as and when the payments fall due and their liabilities exceed their assets.
A Creditors Voluntary Liquidation (CVL) is a formal liquidation process used to close down the affairs of an insolvent company.
A CVL is the voluntary liquidation process initiated by the shareholders of the company. It is the process of closing down the insolvent company and selling its assets in order to pay back a pence in the £ distribution to its creditors (if there are funds available for this). This process will require an Insolvency Practitioner to be appointed as liquidator in order to manage and oversee the process accordingly.
This process compared to a court-led liquidation process gives the director the flexibility of deciding on whom the Insolvency Practitioner will be themselves. It also offers them the chance to purchase the assets and goodwill of the business at a fair value if they wish to start afresh in a new trading company. This highlights a benefit of this insolvent process in that the director can choose to re-start their business if they so wish by using a CVL as a business rescue process; alternatively they can go ahead with full closure of their company.
The court-led liquidation process is called a Compulsory Liquidation. This process is usually initiated by a disgruntled creditor who is tired of waiting for their payments and so begins legal proceedings to try and obtain the funds they are owed.
Why is understanding this important?
As the role of the accountant has developed into a more advisory role for some of their clients, understanding different processes that could benefit or help their clients is important. Being able to offer advice on insolvency and the best practice in closing down a solvent company will help to show that you have researched and understood the best options available. It will also highlight your efficiency and dedication to providing the best service possible for your clients across a wide range of areas.