Limited Liability

Limited liability is a business ownership structure that protects shareholders’ personal assets from losses and debts. The liability is limited to the amount invested in the company. Owners and partners are not accountable for the firm's losses and debts.

There are three different types of limited structures—limited liability partnerships (LLP), limited liability companies (LLC), and corporations. This structure is prohibited in certain states. Also, certain professions like doctors, lawyers, and accountants are not allowed to create an LLP or LLC.  

• Limited liability is a form of business structure that restricts the financial obligations of the owners, partners, members, or shareholders. Even if the business fails, owners cannot lose beyond the amount invested in the business.
• In case of bankruptcy or dissolution, lenders confiscate the firm’s capital and assets. But, beyond that, lenders cannot claim owners’ personal assets.
• Regulations do not allow LLPs or LLCs for certain types of organizations—insurance companies, financial institutions, and banks.

In a limited liability structure, owners’ personal capital or assets of the owners cannot be claimed for paying business debts. Rather, a partner’s liability is restricted to the amount invested in the business.

Even if the business goes bankrupt, owners’ personal assets remain safe—cannot be claimed by lenders. This provision protects the interest of the investors—in practice, this safeguard promotes further investment.

Liability restrictions do not apply to sole proprietorship businesses —the owner and the business are considered the same.

Liability restrictions are applied to the following ownership models:

#1 - Limited Liability Company (LLC)

LLC is a legal corporation owned and managed by the members. The members can be individuals, partnerships, or companies. Members’ interest and liability are restricted to capital invested in the business.  

#2 - Limited Liability Partnership (LLP)

An LLP is a partnership firm where the partners are not obligated to cover business debts using personal assets. Instead, their obligations are limited to the amount invested by them in the business. An LLC can be started by a single individual, but an LLP requires a minimum of two parties who enter into an agreement (charting rights and responsibilities).

#3 – Corporation 

A corporation is a legal business entity where shareholders' financial obligations are restricted to the extent of their investment in the business. Unlike LLCs, corporations require more paperwork and more legal formalities. Corporations are subject to double taxation; LLCs are not.

Restricting liability encourages increased investments. When it comes to profits, partners receive untaxed business profits and are responsible for paying the tax amount individually. In the case of dividends, shareholders are responsible for paying the taxable amount.

Not all states allow LLPs and LLCs—in California, professionals like doctors, lawyers, and accountants cannot create an LLP or LLC. The law does not permit certain business types like banks and financial institutions to create restricted liability firms.

Since every state law doesn't permit LLC or LLP, these businesses cannot be transferred from one state to the other. Even the government cannot call off such non-performing assets.

LLP or LLC members can attempt sluggish economic growth, dishonest projections, mismanagement, fund siphoning, etc. Even so, they don’t entirely face the consequences. This increases the credit risk burden on the lenders.

Let us look at some examples to understand the application of liability:

Example #1

ABC is an LLP with an equity base of $12,000. It is owned by three partners: A, B, and C, with an ownership ratio of 2:1:3.

The firm has taken a loan of $30,000 during the financial year. Next year, the firm was charged with non-payment of interest (loan). In accordance with the law, the partnership was dissolved to repay debt.

Due to the limited ownership structure, owners’ liabilities were limited to $12,000; their loss was calculated as:

• A's loss = 2/6 of $12000 = $4000
• B’s loss = 1/6 of $12000 = $2000
• C’s loss = 3/6 of $12000 = $6000

The lender tries to recover $12,000 from the firm’s assets and capital. The remainder ($18,000) is marked as bad debts. 

Example #2

XYZ is an LLP with a share capital of $200,000. Peter is a member of the company and owns 10% of its shares. The company has taken a loan of $5000,000 during the financial year. However, due to frequent losses, the LLP defaults on loans and ultimately files for bankruptcy.

Now, Peter's liability is limited to:

Peter’s loss = 10% of $200,000 = $20,000

Despite a massive loan burden of $5000,000, Peter's personal assets are protected. He will lose only $20,000—the amount invested in the business.

The two ownership structures differ from each other in the following ways:

This article has been a guide to limited liability and its meaning. We discuss its definition, examples, advantages, and disadvantages along with limited liability vs unlimited liability. You can learn more from the following articles: -

• Journal Entries of Contingent Liability
• Joint Liability
• Unlimited Liability Meaning
• Corporation vs LLC
• Debt Collector