What Does Limited Liability Mean?
Limited Liability and Business Types
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. Common misunderstanding assumes 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 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 ownership, and to 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 open up the owner to full liability. The owner of a business can lose limited liability protection in several different circumstances;
Misuse of funds. If a business owner takes business funds for personal use, or if the owner commingles funds for his or her own gain. For example, if the owner has both business and personal funds in a personal checking account and doesn't clearly separate the two types of funds, this may result in misuse of the funds.
Fraud. Fraud is knowingly misrepresenting something for material gain. For example, if a business owner defrauds customers by concealing the defects in a product or commits insurance fraud by overvaluing assets, the liability protection of the company won't protect the owner. Fraud is a breach of the duties and responsibilities of a business owner, and it is against the law.
Criminal action. If the owner of a business or an employee assaults a customer, the business can't hide behind the company's liability protection. In the case of professional misconduct, you should have malpractice insurance or other professional liability insurance.
Personal guarantees. 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.
A business owner should make sure that he or she does not personally sign a contract which should have been signed on behalf of the business. The corporation or LLC is the party to the contract, not the individual. If the owner signs as an individual, he or she has assumed the liability for that contract.
Limited Liability and Business Types
The limited liability concept is included for all business types except the sole proprietorship. A sole proprietorship doesn't separate the owner from the business, so the business' liability is the owner's, with no limits. That's why most businesses prefer to limit their liability by forming a corporation, LLC, or partnership.
How to maintain "limited liability" protection
It is not always possible to avoid some circumstances that may invalidate or cancel limited liability protection, but there are some measures you and other owners of your business can take to maintain limited liability protection:
- Avoid actions that will be charged with negligence, fraud, or other criminal acts. Sure, 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 corporate and LLC records. 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 and LLC membership.
- Don't mix business and personal funds. Mixing business and personal funds gives the appearance that the two entities are not separate.
- If one of the owners takes money from the business, be sure to record this as either a loan or a disbursement and include the proper documentation of the transaction. A loan to the business or capital contribution should also be recorded and the transaction appropriately documented.
Disclaimer. This discussion about liability is not intended to be tax or legal advice. Before you make any business decisions, check with your attorney.