The concept of liability is important in the business world. Business owners can have personal liability for events that happen in their businesses, but some types of business structures can protect the owner from specific forms of liability.
This article looks at limited liability and how it affects owners of different types of businesses.
What Is Liability?
Having liability in general means that someone is responsible for their actions in certain situations. This concept can have several different meanings, depending on where it is used.
In accounting, liabilities are financial obligations of a company or individual. Common liabilities for business are loans or mortgages payable, expenses due (like taxes), and accounts payable to others.
In law, a liability is a responsibility for the consequence of actions or omissions. In civil law, for instance, liability might be damages (payments), while punishment is a liability in criminal law.
Liability in the legal sense can come from several different situations:
- Negligence means not doing something that a reasonable person would have in a certain situation. For example, a business might be liable if someone was injured on the business property because of faulty equipment that the owner should have had repaired but didn't.
- Non-payment of debts can be a liability, causing a drop in credit rating or bankruptcy for the person or their business.
- Mismanagement of fiduciary duties is a third situation that can cause liability. A fiduciary is someone who is in a position of trust, handling money, for example, or a corporate board member managing a corporation.
What Is Limited Liability for Business Owners?
Limited liability in general means that the liability of a business owner is limited to the amount that the owner has invested in the company.
A common misunderstanding is the assumption that limited liability means that business owners are not liable for anything that happens in the business—but this is not true. "Limited liability" does not mean "no liability" and business owners can be held liable in some circumstances.
The term "limited liability" has been around since the formation of corporations. In the U.S., corporations were formed in part because the owners of the corporation didn't want to be held liable for the actions of the business. Corporations are considered separate entities from their owners and shareholders, so their liability is separate. The term "limited liability" has been extended to the LLC (limited liability company), S corporation owners, and to some types of partnerships.
When Liability Is Not Limited
Losing the protection of limited liability is sometimes called "piercing the corporate veil." In other words, the loss of liability opens up the owner to full liability for their actions in the business. The owner of a business can lose limited liability protection in several different circumstances.
Misuse of Funds
If a business owner uses business funds for personal expenses or if the owner commingles funds for their own gain, they can expose themselves to full liability. For example, if the owner has mixed both business and personal funds in a personal checking account and doesn't clearly separate the two types of funds, this may result in liability for debts of the business.
Conflict of Interest
A conflict of interest occurs when a person in a fiduciary position has competing personal and business responsibilities or loyalties. If the person lets personal interest come before the fiduciary position, that's a conflict of interest.
An example of a conflict of interest would be if a board member of Company A has a personal construction business and the construction business gets the bid to build a development, even if that deal wouldn't be best for Company A.
Fraud and Other Criminal Acts
Criminal acts are punishable by law and they bring liability to the person committing those acts. Fraud, for example, is knowingly misrepresenting something for material gain. Fraud is a breach of duties and responsibilities, and it's both a civil and criminal wrong.
For example, if a business owner conceals the defects in a product or commits insurance fraud by overvaluing assets, the liability protection of the company won't protect the owner.
Employers may also be held liable for the criminal acts of their employees. Plaintiffs in lawsuits sometimes hold both an employer and employee responsible if the employee assaults a customer or another employee.
In some circumstances, a business owner must personally guarantee a business contract; in this case, the personal liability of the owner to fulfill the contract overrides the "limited liability" circumstances.
The best example of this situation is when a business owner must personally guarantee a loan to the business with personal assets. If the business cannot make the loan payments, the business owner is personally responsible for these payments and must pledge personal assets to pay off the loan.
To avoid personal liability for contracts, make sure you sign based on your position with the company. For example, sign as "Jan Smith, President." The business is party to the contract, not the individual.
Types of Businesses With Limited Liability Protection
The limited liability concept is applicable for most business types. Here's how it works for each legal type:
- Sole proprietorship: A sole proprietorship doesn't separate the owner from the business, so the business's liability is the owner's, with no limits.
- Corporation: A corporation is totally separate from its owners (shareholders), so they have limited liability unless they have management duties within the company.
- Limited liability company (LLC): LLC owners (called members) are not usually liable for the company's debts, obligations, or liabilities. Members who have management and control responsibilities don't have increased liability beyond their contribution to the business.
- Partnership: Partners in partnerships may have liability for obligations of the partnership if they are general partners who participate in management. A partnership can also have limited partners, who are merely investors who don't participate in the management of the business. Limited partners have no personal liability for debts or obligations of the partnership.
How To Keep Limited Liability Protection
It is not always possible to avoid some circumstances that may invalidate or cancel limited liability protection. However, there are some measures you and other owners of your business can take to maintain limited liability protection.
Avoid Risky Situations
Avoid actions that will be charged with negligence, fraud, or other criminal acts. You may not have complete control of other corporate shareholders or officers or other LLC members, but monitoring each other and sharing information on possible issues may help keep you out of such lawsuits.
Keep Excellent Records
Set up procedures to make sure you record all decisions of your business. Don't assume that having an LLC rather than a corporation absolves you of the responsibility to keep records. Record all meetings and actions of the board or LLC members.
Don't Mix Business and Personal
Get a separate business checking account, and don't use your personal credit card for business charges. Mixing business and personal accounts gives the appearance that the two entities are not separate.
Record Business Owner Transactions
If one of the owners takes money from the business, be sure to record this as either a loan to the individual or an owner draw or return of capital contribution. The same rule applies to owners contributing money to the business. The transaction should include the proper documentation and signatures.
Consult an Attorney
State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law. For current tax or legal advice, please consult with an accountant or an attorney.
Frequently Asked Questions (FAQs)
What is a limited liability company?
A limited liability company (LLC) is a form of business that combines the characteristics of a partnership and a corporation. Like a corporation, the owners have limited liability protection, but the company operates and the owners are taxed under more flexible operating rules like a partnership.
What types of partnerships offer limited liability?
There are several types of partnerships that have liability protection for partners including limited partnerships (LPs), limited liability partnerships (LLPs), and professional LLPs. Check with your state's business division to see which partnership types they allow.
My business owns other businesses. Are they all liable for each other?
A business that is owned by another business is called a subsidiary. The U.S. Supreme Court has said (in United States v Best Foods) that "...a parent corporation (so-called because of control through ownership of another corporation's stock) is not liable for the acts of its subsidiaries."