Limited Liability: Everything You Need to Know
Limited liability refers to liability that doesn't surpass the amount of money invested in a LLC which protects the assets of associated individuals. 11 min read
What Does a Limited Liability Mean?
Limited liability refers to liability that does not surpass the amount of money invested in a limited liability company or partnership. One of the main advantages of investing in a publicly listed company is the limited liability feature. A shareholder is capable of participating entirely in a company's growth with liability limited to the amount he or she has invested in the company. This is true even if the company goes bankrupt and possesses debt obligations.
If an individual or company is functioning under limited liability, this means that it is not possible to seize the assets of the associated individuals to deal with the debt obligations of a company. Any funds invested with the company directly are viewed as company assets. In the event of insolvency, only these assets can be seized. Personal assets such as houses or cars cannot be seized. The owners of a corporation need to sufficiently capitalize their business, comply with corporate formalities, and complete paperwork to keep the privilege of limited liability.
All assets possessed by the company can be seized and liquidated. These may include equipment and machinery, real estate, investments, and unsold produced goods.
The main reason owners and shareholders consider incorporating is to limit liability.General partnerships and sole proprietorships do not offer limited liability.
A limited liability company or LLC is a distinct and separate legal entity just like a corporation. An LLC can do business, get a tax identification number, and open a bank account under its name.
If you're thinking about becoming an LLC owner, you should keep these liability risks in mind:
- Personal liability for the debts of an LLC
- Liability of LLC for the personal debts of other members
- Personal liability for the actions of the LLC owner when it comes to the business
- Personal liability for the actions of LLC employes or co-owners when it comes to the business
What Is a Limited Liability Partnership?
In a limited liability partnership, the partners have limited liabilit but the general partner possesses unlimited liability. This protects the personal assets of the partners from seizure. If a creditor makes a claim to resolve the insolvency of the company or partnership, only the personal property of the general partner would be at risk.
What Is Limited Liability in Incorporated Businesses?
When it comes to a private company, becoming incorporated grants limited liability to the owners. That's because an incorporated company is viewed as an independent and separate entity legally. Limited liability is beneficial in industries like insurance that often face large losses.
What Are the Differences Between LLCs and Other Business Structures?
There are many advantages of an LLC over other business structures, such as subchapter S corporations. For example, an LLC can issue several classes of company stock with different rights. An S corporation can only offer one class of company stock. A S corporation can have no more than 75 individual shareholders who must be residents of the United States. An unlimited number of individuals, corporations, and partnerships can be shareholders for a LLC.
When it comes to taxes, the LLC has significant advantages in comparison to a limited partnership. The losses of a partner are generally deemed passive losses unless he or she chose to take an active role. Passive losses cannot offset an active income by serving as tax deductions. However, if a partner chooses to play an active role in the management of a firm, he or she can be liable for the debt of the firm. The LLC eliminates this catch-22. All owners of an LLC have no responsibility for the debt of the business. If a LLC incurs losses, these losses can be used against active income as tax deductions.
However, the LLC owners need to meet a few requirements to enjoy these benefits. They must fulfill the "transferability restriction test." This means there are restrictions when it comes to the transfer of ownership interests. This can make the LLC structure unviable for some major businesses. A corporation must be able to transfer its corporate stock easily to attract significant sums of capital. For a smaller company, this restriction is less of an issue since stock ownership transfers are less frequent.
In comparison to other business structures, the LLC is relatively new. Businesses, state governments, and the federal government are still looking for ways to set up tighter regulations for LLCs. Unfortunately, a few investment promoters have turned to LLCs to evade laws related to securities.
Why Are Limited Liability Companies Important?
In every state, having a limited liability corporation protects the shareholders and owners from personal liability in the event of negligence or wrongdoing during business operation. If the LLC is deemed liable for the wrongdoing or negligence of an employee or owner, its assets can be used to fulfill the judgment. The owners of the LLC would not be held personally liable.
Keep in mind that every state has a major exception to the limited liability of LLCs. If you form a limited liability company, you will be personally liable for all negligence and wrongdoing that you commit during business operation. As an LLC owner, you can be held liable personally if you:
- fail to treat the LLC as a separate legal entity rather than an extension of your personal affairs
- perform reckless, fraudulent, or illegal actions intentionally during business operation that cause harm to an individual or the company
- fail to deposit the taxes withheld from the wages of employees
- purposely and directly injure an individual due to negligence during business operation
If it is found that both you and your limited liability company are liable for wrongdoing or negligence, your personal assets and the assets of your LLC may be seized by creditors to satisfy the judgment. It is thus vital that all LLCs and their owners have liability insurance.
The property and money of a LLC cannot be seized by the creditor to help fulfill personal debts against shareholders and owners. However, there are many tactics that creditors can rely on to collect from a LLC owner.
LLC laws differ from state to state when it comes to how many steps a creditor may take. Every state permits creditors to get a charging order against the interest of an LLC owner. Many states have laws that prevent creditors from doing more than obtaining a charging order. However, other states permit creditors to foreclose on the LLC interest of the owner. In some cases, the creditor is able to have the limited liability company dissolved in order to satisfy the debt of the owner.
While none of these tactics are desirable for a LLC, some are far worse than others. After a LLC interest is foreclosed, the creditor will become the owner of the financial rights of the debtor. This includes the right to receive money from the limited liability company. If a court orders the dissolution of a LLC, it must sell all assets and stop doing business.
Single Member LLCs and Asset Protection
In a few states, it is uncertain whether a single member LLC will enjoy the same level of liability protection from creditors as will a multi-member LLC. The purpose of limiting the possible remedies for a personal creditor to a charging order is to provide protection for other LLC members so they won't have to share the responsibility of one member's wrongdoing. Creditors can do more than just request a charging order when it comes to a single member LLC because there are no other LLC owners that need protection. Courts in many states have deemed that a single member LLC cannot enjoy protection from charging orders and that personal creditors are free to use other remedies against the sole LLC member. This includes ordering the dissolution of the LLC and foreclosing on the interest of the member.
Reasons to Consider Becoming a Limited Liability Company vs Reasons to Not Become a Limited Liability Company
Limited liability, also called personal liability, means that the owners cannot be held personally liable for any of the liabilities and debts of an LLC. Undoubtedly, limited liability is the primary benefit of an LLC.
Even though limited liability companies don't have to meet the same rules as corporations, an LLC can be just as beneficial as a corporation. Whether you have hundreds of employees or you're working on your own, an LLC will allow you to grow and expand your business while protecting your assets. There is no need for formalities like extensive corporate records and special meetings for an LLC. Tax flexibility is another major advantage of a limited liability company. For small businesses, a limited liability company is a popular choice due to the protection, simplicity, and the ease of use.
However, it is important to keep in mind that creditors don't want to lose their investment if your business goes bankrupt. Therefore, a creditor may require that owners and shareholders personally guarantee credit cards, business loans, and other credit extensions to your limited liability corporation. In such a situation, you would be held liable if the assets are insufficient.
Advantages of Becoming a Limited Liability Company
- Pass-through taxes. It is unnecessary to file a corporate tax return for a limited liability company. Owners are responsible for reporting profit and loss on individual tax returns to avoid the issue of double taxation. For tax purposes, the IRS does not view a LLC as a distinct separate entity. This also means that the IRS does not tax a limited liability company directly. Rather, LLC owners can decide how they wish to be taxed. For a single member LLC, the owner can have the IRS tax the company like a sole proprietorship. For partners in an LLC, the members can choose to be viewed as a traditional partnership. An LLC can file taxes as a corporation. However, the IRS does classify some LLCs as corporations automatically.
- There is no residency requirement to be the owner of a limited liability company. Owners don't need to be citizens or permanent residents of the United States.
- Owners receive legal protection and have limited liability for business obligations and debts.
- Lenders, suppliers, and partners often view businesses in a better light when owners have formed a LLC.
- Less paperwork is required. It is important to create an LLC Operating Agreement for a LLC to create rules for the business. Otherwise, the rules of the state will govern the company.
Disadvantages of Becoming a Limited Liability Company
- The inability to offer shares of stocks limits growth potential for an LLC.
- Lack of uniformity. An LLC in one state will be treated differently from an LLC in another state.
- Earnings from an LLC can be subject to self-employment tax.
- Tax recognition on assets that have appreciated. This is possible if an existing business is converted to an LLC.
- In a corporation, there are specific roles, such as employees, directors, and managers. However, most LLCs do not have specific roles. This can make it hard for the corporation and investors to know who is the boss and who can sign contracts. An LLC Operating Agreement can eliminate some of this confusion.
- The life of an LLC is often limited. In most jurisdictions, if a member leaves an LLC it is dissolved. On the other hand, if a shareholder leaves a corporation, this does not affect the identity of the corporation in question. An Operating Agreement can help LLC members deal with this weakness.
Common Mistakes When Forming a Limited Liability Company
Mistake #1: Refusing to get legal assistance from the start.
While many small businesses experience a significant legal event every few years, not all of them seek legal assistance. Not only does forming a limited liability company take a lot of difficult work, but it is very easy to make a mistake. Reaching out to a lawyer for legal assistance to form a limited liability company will help prevent issues down the line.
Mistake #2: Keeping important information from lawyers and partners.
Communication is a must when it comes to forming a limited liability company. It is important to tell your lawyer and the other LLC members about all significant events.
Mistake #3: Failing to complete important documents.
When it comes to documents required for a transaction, all relevant parties must initial, sign, and date these documents. You should also copy and distribute these documents to these relevant parties.
Mistake #4: Using legal forms from the Internet.
While the legal forms you find online can be a good way to start, these are in no way comprehensive. If you only use these forms, you will be missing a lot of information.
Mistake #5: Hiring a generalist.
If you're seeking legal assistance, it is better to hire a lawyer who specializes in business structures. A specialist is a must for complex situations.
Frequently Asked Questions
- What documents should I fill out to create limited liability company?
In order to form a LLC, you need to file the Articles of Organization with an appropriate state agency, such as the Secretary of the State. The members of the LLC will need to form an operating agreement, which will set rules for business operation and rights of the owners. You may need to apply for a tax identification number for the LLC with the IRS.
- Can my limited liability company last forever?
A LLC can have an unlimited life due to changes in the IRS code and state laws.
- Is there a difference between the member and manager of a limited liability company?
A member of a LLC is an owner. The LLC member is comparable to a stockholder. On the other hand, the members of an LLC choose a manager to help run the LLC. The manager is comparable to a director. A member can be a manager.
- Must a limited liability company hold meetings?
Unless the Operating Agreement of the LLC requires meetings, there is no need for an LLC to hold meetings. Fewer formalities like meetings are required for an LLC.
- What are the main differences between a limited liability company and an S corp?
Many of the tax characteristics of a S corporation are similar to that of an LLC. However, a LLC has fewer restrictions and more flexibility. For example, an S corporation is not permitted to have more than 100 individual stockholders and is unable to issue several classes of shares. While an LLC is not subject to as many formalities, it must pay Medicare and Social Security taxes on the profits.
- How much will it cost to create and run a limited liability company?
Many states charge LLCs an annual fee and require an annual report of some kind. Some states require LLCs to pay state taxes.
- Do I need an attorney to form a LLC?
An attorney is not necessary to form a limited liability company. It is possible to fill out the legal paperwork and file it without legal assistance. It is also possible to use the services of a provider of professional business formation services. However, it is recommended that business owners without legal experience reach out to lawyers for assistance.
- How many people are needed to form a limited liability company?
Changes in IRS code and state laws now permit single-member LLCs.
Steps to File a Limited Liability Company
- Select a legal name and reserve it if possible.
- Create a draft of the Articles of Incorporation and file it with the Secretary of State.
- Determine which managers or members will run the LLC.
- Determine how many owners will be in the LLC.
- Apply for a business certificate and licenses relevant to your industry.
- File the Form SS-4 or go to the Internal Revenue Service website online to apply and obtain an Employer Identification Number (EIN).
- Apply for ID numbers required by state government agencies. You will probably be required to pay for disability, unemployment, and other payroll taxes. In addition to the EIN, you will need tax ID numbers.
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