What is Limited Liability: Everything You Need to Know
Limited liability is one of the biggest advantages of investing in a publicly-listed company.8 min read
What is Limited Liability?
Wondering what is limited liability? It is the legal protection available to the shareholders of privately- and publicly-owned companies, under which the financial liability of each shareholder for the company's debts and obligations is limited to the value of the shares they own in the company. Limited liability is one of the biggest advantages of investing in a publicly-listed company.
A shareholder can enjoy the growth of a company, while restricting their liability to the amount they have invested in the company. Their other personal possessions are protected, even if the company goes bankrupt while still having outstanding debt.
If a business owner has "limited liability," it means that he or she is not personally responsible for business debts and obligations of the corporation.
The best explanation of limited liability is simply that you risk only that which you put into your business. Your personal possessions or fortune are not liable for creditors’ claims against the company. Limited liability helps someone run a business without putting their personal treasures at risk in case the business goes under.
No member of a company that is protected by limited liability can be in charge of any company debts that exceed the amount that person has put in.
Like a corporation, a limited liability company, or "LLC," is a separate and distinct legal entity, meaning a limited liability company can get a tax identification number, open a bank account, and do business, all under its own name.
Forming a Limited Liability Partnership
In a partnership, the “limited” partners have limited liability. The limited liability feature protects a limited partner's personal assets from being subject to seizure to satisfy creditor claims. A “general” partner, however, has unlimited liability, meaning their personal property is always at risk.
Limited Liability and Incorporated Businesses
Being incorporated as a private company can provide owners with limited liability because an incorporated business is considered a separate and independent legal entity. It is especially desirable to seek limited liability when dealing in industries such as the insurance business, which can leave itself open to catastrophic losses.
A Breakdown of Limited Liability
When a company has limited liability, the personal assets attributed to the members of the company are not subject to seizure in order to repay company debts. However, funds invested in the company, such as purchased shares of the company, are considered assets of the LLC and can be seized to pay company debts.
Other company assets, such as real estate, investments made by the company, products that have been produced but not yet sold, and the equipment and machinery used to make those products, are also subject to being seized and liquidated.
Maintaining Limited Liability
Many business entity types offer the protection of limited liability for their owners. The most common are limited liability companys (LLC) and corporations.
Each business entity has its own advantages and drawbacks, but both offer their owners limited liability protection.
An LLC must be properly maintained to be able to continuously offer its members full liability protection. If an LLC is a company in name only, the courts will consider its corporate structure as false and will not offer the owners the protection provided by an LLC.
Even in a limited liability business, an owner may be responsible for amounts beyond his or her investment.
Not Everyone Can Operate a Limited Liability Business
Not all companies, businesses, or practices can operate as LLCs. Attorneys, physicians, and tax preparers, for instance, cannot by law and ethics protect themselves by limiting their liability. They need to be personally responsible for their actions so that they make decisions carefully.
How an LLC Can Protect You
The best benefit of a limited liability company is that its owners have "limited liability," meaning that they are almost never liable for the debts of the company on a personal level.
An LLC is Flexible, Scalable, and Simple
Limited liability companies aren't bound by the stringent rules to which corporations must adhere, but they have their own benefits as a vehicle to be used in business.
If you have one employee or hundreds, an LLC will protect you and still allow the company to expand and grow. When operating an LLC, you do not face any requirements to hold special meetings, keep extensive corporate records, or perform many other formalities that corporations are required to do. They even offer many flexible tax options, so owners can come up with a tax plan that works best for the business.
Securities Laws When Issuing Stock
Securities laws are in place to help protect financial investors from unsavory company owners. They often require corporations to meet some stringent regulations in order to accept financial investments in exchange for stock in the company.
The Securities and Exchange Commission, or SEC, requires a corporation to register their sale of stock with it and its state agencies before being able to issue any stock to initial shareholders. Registering company shares is time-consuming, usually involving additional accounting and legal fees.
Luckily for small corporations, many can forego the registration process due to exemptions provided under state and federal laws. Many states have their own type of the small business federal exemption from registration.
If you are creating a corporation with just a few associates, one where you will be the one who is actively managing operations, you will definitely qualify for a small business exemption, and there will be no registration paperwork to file.
Corporations Differ From Sole Proprietorships, LLCs, and Partnerships
When dealing with partnerships or sole proprietorships, as opposed to corporations, limited liability for owners’ personal assets is not available for business debts. In other words, creditors of such companies can file suit against the owners' personal assets to retrieve what is owed to them. But because no formal paperwork is required to organize and operate a partnership or sole proprietorship, they are much easier to form than a corporation.
There is also a type of business called a limited liability company, or LLC, which, like a corporation, also offers limited liability for personal assets. Formal paperwork is, however, required to create a limited liability company, but operating a limited liability company is easier than operating a corporation. One example would be that limited liability company owners don’t need to follow corporate formalities such as holding regular management and ownership meetings.
Corporations also are different from other company structures in taxation procedures because they have to pay income tax on their profits, or the surplus of income available after the corporation pays deductible expenses such as salaries and bonuses.
With sole proprietorships, limited liability companies, and partnerships, profits are not subject to income tax, allowing them to flow through to the business owners, who must then report losses or income from their businesses on individual tax returns.
What is a Corporation?
What sets the corporation apart from all other types of businesses is that a corporation is an independent, legal entity, separate from the people who own, control, and manage it. In other words, corporation and tax laws view the corporation as a legal "person" that can enter into contracts, incur debts, and pay taxes apart from its owners.
Other important characteristics also result from the corporation's separate existence. A corporation does not dissolve when its owners (shareholders) change or die, and the owners of a corporation have limited liability -- that is, they are not personally responsible for the corporation's debts.
What is a Professional Corporation?
A professional corporation is a special kind of corporation that only members of certain professions, such as lawyers, doctors, and healthcare workers, can create.
By forming a professional corporation, professionals can limit their personal liability for the malpractice of their associates.
Who is Best Suited to Start a Corporation?
Due to the formalities and expenses required to set up a corporation and issuing stock, you should only form a corporation only if there is a valid reason, such as:
- You should form a corporation only if your company needs to be able to issue stock options or stock to entice certain desired employees or additional outside investments.
- You should form a corporation if your business earns enough in profits that a large amount of income tax can be saved by keeping some of those profits in the corporation every year. This is known as "income splitting." It helps a corporation take advantage of lower tax rates on income of up to $75,000.
- You should form a corporation only if you own a family business and want to start making ownership gifts to family members when making an estate plan, or in planning for the generation of owners to come.
Forming a Corporation
In order to form a corporation, you must first have what are called “articles of incorporation" with your state government’s corporations department, accompanied by a fee of $100 to $800, depending on the state in which you file.
Your articles of incorporation contains company information such as:
- The corporation's name
- The legal address of the corporation
- The registered agent’s name and address (this is the individual who will be made available to the public to answer and address their questions and concerns)
- The corporate directors’ names, in some states
In addition, a corporation must make a more in-depth document, known as their "corporate bylaws." This document outlines the rules that will govern the corporation and must include voting rights and decision-making procedures.
Before starting business as a corporation, there must first be a meeting of the board of directors to handle some formalities. Also, stock shares must be issued to the first owners.
Is There More Paperwork With a Corporation Than With Other Types?
In short, yes. There are statutory rules that corporations must observe, which unincorporated businesses, such as sole proprietorships, LLCs, and partnerships, don’t.
There is a separate corporate tax return form that corporations must file and pay their taxes on. They also have to establish a double-entry system for bookkeeping that will record business dealings, including daily reports and general pay tracking.
How Corporate Income is Taxed
Corporations don’t have to pay individual taxes on all business profits, unlike sole proprietors, owners of limited liability companies, or partnerships. Owners of corporations only pay taxes on the profits they receive from bonuses, dividends, and salaries. A corporation pays a different tax rate, however, on profits that remain in the company year over year. These are known as retained earnings.
With an S corporation, all of its profits and losses trickle down to the owners, who must declare them on their own individual tax returns.
Double Taxation - Corporate Income Can Be Taxed Twice
Corporations are only taxed twice in the instance of earnings, or dividends, that are paid out to shareholders. This is only true, however, for shareholders who are employed by the corporation and also pay themselves a salary and bonus.
A corporation can declare salaries and bonuses as essential business expenses, meaning that they are not required to pay any corporate taxes on them. An employee can avoid being taxed twice by taking profits in the form of their annual pay and related bonuses, instead of through dividends.
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