What Does Limited Liability Mean?
Limited Liability and Business Types
What is Liability?
The term "liability" 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, accrued expenses due, and accounts payable.
In the law, a liability is a responsibility for the consequence of actions or omissions. In civil law, liability might be damages (payments); in criminal law, the liability is punishment.
Liability in the legal sense can come from:
Negligence - not doing something that a reasonable person would have done in the situation. For example, a business might be liable if someone was injured on the business property because of faulty equipment that should have been repaired and wasn't.
Non-payment of debts, leading to bankruptcy. The liability, in this case, is concerned with who must pay the debt.
What is Limited Liability in Business?
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 opens 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 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 misuse of the funds.
Conflict of interest. A conflict of interest happens when the duties of 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. 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.
If you are signing a contract for your company, make sure you don't sign personally, but sign based on your position with the company. For example, sign as "Jan Smith, President." The business is the party to the contract, not the individual. If the owner or executive signs as an individual, they assume the liability for that contract.
Limited Liability and Business Types
The limited liability concept is applicable 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.
Holding Companies and Liability
A holding company is an umbrella organization that owns one or more businesses, called subsidiaries. The holding company manages the companies it owns. One purpose of forming a holding company is to separate the liability of each company from that of the others. For example, a holding company might own a rental property and the offices of a dentist. Each has separate liabilities.
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."
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.