One compelling reason that influences business owners to either incorporate or form a limited liability company under which to conduct their business operations is the desire to limit personal liability for the debts and other obligations of their business. Typically, a shareholder is not liable for the debts of the business. In most instances, the most that a shareholder will lose in an unsuccessful business venture is the shareholder’s initial capital contribution and the shareholder’s time. This insulation from personal liability is what encourages entrepreneurs and sole proprietors to form limited liability entities under which to operate the business.
Unfortunately, many business owners fail to recognize that a business owner and shareholders may, in certain circumstances be held liable for the debts of the business.
This liability arises when the corporate veil is pierced. The corporate veil may be pierced when a business is sued for a debt or tort or some other obligation. As part of the lawsuit, the plaintiff may allege that the company did not operate as legal entity separate and apart from the officers, directors and shareholders such that the company was actually the alter ego of the shareholders, officers and directors and not a separate legal entity. As such, the plaintiff argues that these individuals should be held liable individually for these business debts and obligations.
When the corporate veil is pierced, the personal assets of the company’s officers, directors, and shareholders become available for the plaintiff’s damages, thus defeating the whole purpose of forming a corporate entity. Here are some steps you should take to protect yourself, as a shareholder, from becoming liable for the debts of your business.
First and foremost, operate your business like a business. Do not pay for personal expenses out of your business. Do not pay business expenses personally. In other words, the business pays its bills and you pay your bills – do not commingle your personal affairs with the operations of your business.
Second, memorialize major decisions by the business with minutes approving these transactions. Typically, a business should memorialize with corporate minutes all real estate purchases or sales and leases as well as major purchases of equipment and vehicles. Minutes should also be prepared regarding the issuance of shares of the company’s stock, the election of directors, appointment of officers, and approving employment contracts. At a minimum, annual meetings of directors should be held as well as an annual shareholder/member meeting. These meetings may also be memorialized with written unanimous consents of directors. The bylaws or operating agreement should provide guidance as to the requirements for the annual meeting of shareholders or members.
Third, the business should follow and maintain accurate and complete financial records as well as filing all required tax returns. Following these basic rules will help to insure that your limited liability entity is treated as separate and distinct from you individually thus providing you insulation from business liability such as debts. Failing to do so your personal financial security as risk.
In business, unlimited liability means that the owner(s) of a business are entirely responsible for its debts.
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In contrast with limited liability, unlimited liability refers to business owners who are legally liable for any debt their business might accrue. There’s no maximum amount of debt that is capped, so any involved partners and owners are legally responsible for the full amount.
Unlimited liability vs. limited liability
Limited liability businesses are a popular business structure, as they allow business owners and partners to add a level of protection to their fiscal responsibility behind the business.
By choosing a limited liability structure, a separate entity is created for the business itself, separating it from the personal accounts of the owners and/or partners. It serves to separate not only bank accounts but also assets and liabilities.
Unlimited liability means that any owners/shareholders share responsibility for debts in the case that a business fails, or to settle any legal proceedings (for example, a lawsuit due to employee injury on the job).
In the event of loss, any capital from the business would be seized, as could any personal assets that could contribute to covering the debt.
When a business faces unlimited liability
The reason that most have heard of a limited liability company (often referred to just as an ‘LLC’) is due to its popularity over unlimited liability as far as protection for the personal assets of the business owners and shareholders. Incorporation as an LLC means only the business capital and investments are at risk.
While it might seem like the obvious choice, there’s one main reason that a company might choose to proceed as an unlimited liability company: there are no disclosure requirements. This means that there aren’t public reports on the money coming into or flowing out of the business.
Many businesses are by default considered unlimited liability. Unincorporated businesses such as sole traders have unlimited liability. In other words, the individual who has started the business will be personally liable for business debts until they choose to incorporate.
In the UK, a business can incorporate as a private unlimited company to maintain unlimited liability.
April 12, 2022 April 12, 2022/ Steven Bragg
Unlimited liability means that each owner of a business can be held personally liable for the debts of the organization. The unlimited liability concept is of particular concern for large and unexpected liabilities that a business does not plan for and has no cash reserves against, such as an adverse outcome of a lawsuit against the firm. Because of this unlimited liability drawback, many people prefer to structure their businesses to have limited liabilities, where investors can only lose the amount of their original investments.
The unlimited liability concept is attached to sole proprietorships, general partnerships, and the general partners of limited partnerships. Liability can be limited by using the corporation, limited partnership, or limited liability corporation structures. Another way to mitigate the unlimited liability problem is to obtain insurance to cover the most likely and highest-risk areas of a business.
Example of Unlimited Liability
An individual invests $50,000 in a sole proprietorship. The sole proprietorship then incurs $200,000 of debts. The individual is personally liable for the entire $200,000, even though he only invested $50,000 in the business. This means that a creditor could legally seize the personal assets of the individual in order to pay the debts of the business.
April 12, 2022/ Steven Bragg/
This is a business run by one individual for his or her own benefit. It is the simplest form of business organization. Proprietorships have no existence apart from the owners. The liabilities associated with the business are the personal liabilities of the owner, and the business terminates upon the proprietor's death. The proprietor undertakes the risks of the business to the extent of his/her assets, whether used in the business or personally owned.
Single proprietors include professional people, service providers, and retailers who are "in business for themselves." Although a sole proprietorship is not a separate legal entity from its owner, it is a separate entity for accounting purposes. Financial activities of the business (e.g., receipt of fees) are maintained separately from the person's personal financial activities (e.g., house payment).
Partnerships-General and Limited
A general partnership is an agreement, expressed or implied, between two or more persons who join together to carry on a business venture for profit. Each partner contributes money, property, labor, or skill; each shares in the profits and losses of the business; and each has unlimited personal liability for the debts of the business.
Limited partnerships limit the personal liability of individual partners for the debts of the business according to the amount they have invested. Partners must file a certificate of limited partnership with state authorities.
Limited Liability Company (LLC)
An LLC is a hybrid between a partnership and a corporation. Members of an LLC have operational flexibility and income benefits similar to a partnership but also have limited liability exposure. While this seems very similar to a limited partnership, there are significant legal and statutory differences. Consultation with an attorney to determine the best entity is recommended.
Corporation
A corporation is a legal entity, operating under state law, whose scope of activity and name are restricted by its charter. Articles of incorporation must be filed with the state to establish a corporation. Stockholders' are protected from liability and those stockholders who are also employees may be able to take advantage of some tax-free benefits, such as health insurance. There is double taxation with a C corporation, first through taxes on profits and second on taxes on stockholder dividends (as capital gains).
Small Business Corporation (S-Corporation)
Subchapter S-corporations are special closed corporations (limits exist on the number of members) created to provide small corporations with a tax advantage, if IRS Code requirements are met. Corporate taxes are waived and reported by the owners on their individual federal income tax returns, avoiding the "double taxation" of regular corporations.
Advantages/Disadvantages
Sole Proprietorship
- Simplicity of organization-this is the most common form of business organization in the United States because it is the easiest and least expensive to establish.
- Minimum legal restriction-fewer reports have to be filed with government agencies. There are no charter restrictions on operations.
- Ease of discontinuance-the business can be terminated at the will of the owner.
- The owner is truly the boss, making all decisions, keeping all profits, and assuming responsibility for all losses and debts.
- Difficulty in raising capital-this can be a problem since an individual's resources are typically less than the pooled resources of partners.
- Limited life of the business-untimely, unanticipated, or unplanned removal of the proprietor from the operation of the business may have ramifications for creditors.
- Unlimited liability-this is by far the greatest disadvantage to the proprietorship. Even though proprietors may invest only part of their capital in the business, they remain personally liable to the full extent of their assets for the liabilities of the business.
Partnership
- Greater possible capital availability
- Greater resources for decision making, support, creative activity
- Unlimited liability in general partnerships
- Divided authority-having to divide the authority for making decisions among the partners can delay the decision-making process and occasionally lead to disagreement.
Limited Liability Company
- Allow greatest flexibility for customizing the structure of the business
- Limits member liability
- In many states, an LLC may have only one member (have the benefits of a sole proprietorhop but limits liability).
- Requires comprehensive operating agreement because of the high degree of variability/flexibility
Corporation/S-Corporation
- Limited liability to stockholders-liability is limited up to the amount invested personally in the business. In addition, personal assets may not be seized by creditors to satisfy debts (although now creditors often request personal guarantees on business loans).
- Perpetual life-the business continues as a legal entity. Shares in the corporation can be passed on to heirs.
- Ease of transferring ownership-stockholders can sell their shares when they desire, if there is a market.
- Ease of expansion of the company-greater capacity to raise capital by legal sale of stock.
- Government regulation-a corporate charter must be obtained from the state, and the corporation is subject to all state and record keeping regulations that pertain to corporations.
- Costs to organize a corporation are higher.
- Unless permission is obtained from other states, the corporate charter restricts operation to the state where it was issued.
- Double taxation feature unless S-Corporation election is made.