Limited liability is a legal status that limits a person’s financial responsibility for the debts of their business to a fixed sum. It is a fundamental characteristic of a number of incorporated business structures that exist as distinct legal entities, including limited companies, limited liability partnerships, and limited partnerships.
If you’re considering starting your own business and wondering which structure is best, it’s important to understand the concept of limited liability, what it means in practice, and how it compares to unlimited liability.
Limited companies can be set up with or without share capital. Those with share capital are limited by shares, whereas companies without share capital are limited by guarantee. The members of both types of limited company benefit from ‘limited liability’.
Beyond the limited liability of members, companies are responsible for their own debts, obligations, and actions. Since companies exist as legal entities separate from their members and directors, creditors generally cannot recover debts from the personal assets of members or directors. They can usually only claim from the assets of the business. However, there are exceptions, which we discuss later in the post.
Company shareholders often pay the issue price of their shares as soon as they are issued, whether during the company formation process or after incorporation.
However, each company has its own rules on paying for shares. These rules are set out in the articles of association and, if one exists, a shareholders’ agreement.
Some companies allow members to hold shares unpaid or partly paid until a specified future date or when the director s issue a ‘ call on shares ’ . When a company issues a call notice, members must pay some or all of the outstanding sum they owe on their shares within the required timeframe .
In a company limited by guarantee, the guarantors usually contribute the guarantee sum when the company is wound up (for example, because the company is insolvent and cannot pay its debts) .
If a company becomes insolvent, th e capital raised from the issue price of the shares or guarantees contributes towards paying off its outstanding debts during the liquidation process.
Limited liability partnerships (LLPs) do not have shares. They are set up by two or more LLP members (also called ‘partners’), each of whom has limited liability for the LLP’s debts and actions.
LLP members’ financial liability for any outstanding business debts upon the winding up of the partnership is limited to the amount of capital they agreed to contribute to the business and/or any personal guarantees they provide.
Limited partnerships (LPs) and Scottish limited partnerships (SLPs) have two types of partners: limited and general.
In exchange for assuming greater financial risk, general partners control and manage the business and have the power to make binding decisions on behalf of the entire partnership.
In certain circumstances, limited liability does not apply to company members, LLP members, or limited partners. This situation is known as ‘lifting’ or ‘piercing’ the corporate veil – a theoretical barrier that separates the legal personalities of the person and the business.
A person with limited liability protection may be personally responsible for the debts of their business if they provide a personal guarantee for a business loan and the company or partnership is unable to repay it.
LLP members, limited partners, and company members (if they are also directors) may also lose the benefit of limited liability in the following situations:
In these situations, creditors and claimants can hold individuals personally liable for the business’s debts. They can make claims on the individual’s personal assets (e.g. property, savings, investments) and use those assets to recover payments owing to them.
As a business owner or company director, understanding the financial risk and taking steps to limit your exposure to personal liability for business debts are crucial.
Whilst it is rarely possible to remove all personal risk in business, there are several things you can do to minimise the potential for personal liability.
An accountant can help you manage your business finances appropriately and provide specialist tax advice. Whereas, a solicitor can advise on matters such as client and supplier contracts, personal guarantees, shareholders’ agreements, and LLP agreements.
In stark contrast to limited liability protection, unlimited liability means that a person’s financial liability is not capped at a certain amount. There is no limit to how much money the person may be liable for if their business fails or faces legal claims.
Sole traders, shareholders in a private unlimited company (as opposed to a private limited company) , general members of LPs , and partners in general (traditional) business partnerships have unlimited liability. T his is because , except in the case of a private unlimited company, there is no separation between the person and the business in terms of legal personality and liability .
Consequently, creditors and other third parties to whom the business owes money can make claims on the person’s personal assets. Essentially, their personal assets, including their home and savings, are at risk if the business can’t pay its debts or meet its contractual obligations. In serious cases, it can lead to personal bankruptcy.
Despite the lack of financial protection, business structures with unlimited liability remain popular and are suitable for many people. It depends entirely on the owner’s needs or preferences and the type of work they do.
If you’re unsure which business structure is best for you, we recommend consulting an accountant or independent business advisor. They can provide tailored advice and help you make an informed decision.
We’ve explained the concept of limited liability as it relates to incorporated business structures, what it means in practice, the situations where this protection may not apply, and how it compares to unlimited liability.
Hopefully, you now have a clear understanding of limited liability and why it is such an important consideration when starting a business or getting involved with an existing limited company, LLP, or LP.
If you have any questions about this topic or want to know more about setting up a limited company or LLP , please comment below or contact our London-based company formation experts.