What is limited liability?
Limited liability is a type of legal structure for an organization where a business loss will not exceed the amount invested in a partnership or a limited liability company. In other words, the private assets of investors and owners are not threatened in the event of a business failure. In Germany, it’s called aftungHeschränkter bhe mesellschaft g.
One of the biggest benefits of investing in publicly traded companies is the limited liability function. While a shareholder can participate fully in the growth of a business, his liability is limited to the amount of investment in the business, even if he subsequently goes bankrupt and has remaining debt obligations.
[Important: limited liability allows for other legal innovations such as bankruptcy protection and the classification of firms as juridical persons.]
How Limited Liability Works
When an individual or business operates with limited liability, this means that the assets allocated to the associated individuals cannot be seized for the purpose of repaying debts assigned to the business. Funds that have been directly invested in the business, such as the purchase of shares in the business, are considered assets of the business in question and can be seized in the event of insolvency.
All other assets deemed to be in the possession of the company, such as real estate, equipment and machinery, investments made on behalf of the institution and all goods which have been produced but which have not been sold , are also subject to seizure and liquidation.
Without limited liability as a legal precedent, many investors would be reluctant to acquire an interest in businesses and entrepreneurs would be wary of starting a new business. Indeed, without limited liability, if the business loses more money than it has, creditors and other stakeholders could claim the assets of investors and owners. Limited liability prevents this from happening, and therefore the most that can be lost is the amount invested, with all personal assets held as out of bounds.
Key points to remember
- Limited liability is a legal structure of organizations such as businesses that limits the extent of an economic loss to the assets invested in the organization and that keeps the personal assets of investors and owners out of bounds.
- Without limited liability as a legal precedent, many investors would be reluctant to acquire an interest in companies and entrepreneurs would be wary of starting a new business.
- There are several limited liability structures, such as limited liability companies (LP and LLP), limited liability companies (LLC) and companies.
Limited Liability Partnerships
In a partnership, the sponsors (LP) have limited liability while the general partner has unlimited liability. The limited liability function protects the personal property of the partner against the risk of being foreclosed to satisfy the claims of creditors in the event of the insolvency of the company or partnership while the personal property of the general partner would remain in danger.
Another advantage of an LLP is the ability to bring in partners and let them out. Because a partnership agreement exists for an LLP, partners can be added or removed as indicated in the agreement. This is useful because the LLP can always add partners who bring existing business with them. Usually, the decision to add requires the approval of all existing partners.
Overall, it is the flexibility of an LLP for a certain type of professional that makes it a superior option to an LLC or other entity. As an LLC, the LLP itself is an intermediary entity for tax purposes. This means that the partners receive untaxed profits and have to pay the taxes themselves. An LLC and an LLP are preferable to a company, which is taxed as a whole, and then its shareholders are taxed again on distributions.
The actual details of a limited company depend on where you create it. Generally, however, your personal wealth as a partner will be protected from any legal action. Basically, liability is limited in the sense that you will lose assets in the partnership, but not outside assets (your personal assets). Partnership is the primary target of any lawsuit, although a specific partner may be held responsible if they have personally done something wrong.
Limited liability in incorporated businesses
In the context of a private company, incorporation can incur the limited liability of its owners, since an incorporated company is treated as a separate and independent legal entity. Limited liability is particularly desirable when dealing in sectors which may suffer massive losses, such as insurance.
A limited liability company (LLC) is a corporate structure in the United States by which the owners are not personally liable for the debts or liabilities of the company. Limited liability companies are hybrid entities that combine the characteristics of a company with those of a partnership or a sole proprietorship.
Although the characteristic of limited liability is similar to that of a corporation, the availability of flow-through taxation for the members of an LLC is a characteristic of partnerships. The main difference between a partnership and an LLC is that an LLC separates the company’s business assets from the owners’ personal assets, isolating the owners from the LLC’s debts and liabilities.
As an example, consider the unhappiness that has plagued many Lloyd’s of London Names, who are individuals who agree to take on unlimited insurance risk liabilities in exchange for the stocking of insurance premiums. In the late 1990s, hundreds of these investors had to file for bankruptcy in the face of catastrophic losses on asbestos claims.
Compare that with the losses suffered by shareholders of some of the biggest companies going bankrupt, such as Enron and Lehman Brothers. Although the shareholders of these companies lost their entire investment in them, they were not liable for the hundreds of billions of dollars owed by these companies to their creditors as a result of their bankruptcy.