Limited Liability Meaning
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.
Table of contents
- 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.
Limited Liability Explained
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 Owners Capital, also known as Shareholders Equity, is the money invested in a business by the owners (in the case of a sole proprietorship or partnership) or shareholders (in the case of a corporation) and is the portion of the total assets funded by the owners/shareholders money.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)
LLCLLCLLC stands for Limited Liability Company. A Limited Liability Company is a combination of partnership or sole proprietorship and a corporation and has emerged in the United States, in which the owners' or investors' liability is limited by the amount of stock they own or by any other defined means. 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 investedCapital InvestedCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc. 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 taxationDouble TaxationDouble Taxation is a situation wherein a tax is levied twice on the same source of income. It usually occurs when the same income is taxed both at corporate as well as at the individual level.; LLCs are not.
Advantages and Disadvantages
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 dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity., 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 assetsNon-performing AssetsNon-Performing Assets (NPA) refers to the classification of loans and advances on a lender's records (usually banks) that have not received interest or principal payments and are considered "past due." In the majority of cases, debt has been classified as non-performing assets (NPAs) when loan payments have been outstanding for more than 90 days..
LLP or LLC members can attempt sluggish economic growthEconomic GrowthEconomic growth refers to an increase in the aggregated production and market value of economic commodities and services in an economy over a specific period., dishonest projections, mismanagement, fund siphoning, etc. Even so, they don’t entirely face the consequences. This increases the credit riskThe Credit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection. burden on the lenders.
Let us look at some examples to understand the application of liability:
ABC is an LLP with an equityEquityEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company's balance sheet. 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.
XYZ is an LLP with a share capitalShare CapitalShare capital refers to the funds raised by an organization by issuing the company's initial public offerings, common shares or preference stocks to the public. It appears as the owner's or shareholders' equity on the corporate balance sheet's liability side. 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.
Limited Liability Vs Unlimited Liability
The two ownership structures differ from each other in the following ways:
|A business structure where owners’ obligations are limited to the extent of their investment.
|A business structure where the owners are personally liable for the firm’s debts and losses.
|Limited Liability Partnership (LLP), Limited Liability Company (LLC), and Corporation
|Sole Proprietorship and General Partnership
|Seizure of Owner’s Personal Assets
Frequently Asked Questions (FAQs)
Yes, one LLC can be a member of another LLC. Moreover, one LLC can own 50-100% membership interest in another LLC.
Initially, it is better to form an LLC to avail of tax write-offs and safeguard members’ personal assets. However, an LLC can acquire the status of an S corp when the business expands—to avoid self-employment tax. This way, firms can avoid double taxation.
An LLC is a separate legal entity; therefore, the ownership of the business assets lies with the company. Therefore, firms’ assets can be used to settle debts and obligations at the time of dissolution.
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: –