What Is Limited Liability and Why It Is Important?

What is Limited Liability?

The best way to explain limited liability is this - you risk what you put in. In other words, limited liability is a way to make sure that a person who is engaging in business does not risk his or her personal possessions in case the business fails. Any investor, partner, or member of the company that by law has limited liability cannot be made responsible for any unfulfilled company obligations and debts that are more than the amount that the person has invested.

Jack and Jill

Here is a simple comparison. Jack and Jill are friends. Jack is a handy guy and Jill is a great cook. To earn money from their talents, both start their own business. Jack earns his living by doing renovations. He bought his own equipment and simply advertises his services under his own name. Jack is a sole proprietor.

Jill decided to open a bakeshop. Before going into business, however, Jill has formed a small corporation (an S-Corporation), called Jill's Cakes, Inc. Jill invested her savings into Jill's Cakes, Inc. as a starting capital and then bought her baking equipment and leased her shop on behalf of her corporation. So long as things go well for Jack and Jill there are almost no differences between the two ways of doing business.

As soon as things turn sour though, the differences become apparent. One day, Jack mopped the floor right before leaving the apartment he just painted, but forgot to put up a sign. The owner walked in, slid on the wet floor and broke an ankle. He is suing Jack for medical expenses and lost wages. Jill accidentally dropped a peanut in a wrong batch of batter and caused a severe allergy attack in one of her customer. That customer is suing her for medical bills and pain and suffering.

What is at risk for Jack and Jill? Jack is risking everything he owns - his work equipment, his truck, his house, his personal belongings. So long as there is a judgment against him, Jack must sell anything he owns to pay it. Jill is risking only her business assets - her cooking equipment, her cash reserves, and anything else owned by Jill's Cakes, Inc. But her personal things, such as her car and her apartment, are safe. Her business may become bankrupt, but her life will not be (completely) destroyed.

Of course, this story describes a worst case scenario. Many businesses prosper without many troubles. But many also fail, and it is so easy for a business owner to take advantage of limited liability that everyone should do it.

Maintaining Limited Liability

Several types of business entities offer their owners the protection of limited liability. The most popular are corporation and limited liability company (LLC). Each of these entities has its own advantages and drawbacks, but both offer their owners limited liability protection.

A few things are important to remember in the context of limited liability. First, a company must be properly maintained in order to offer full liability protection that it is designed to offer. In short, if a company is only a company in name, but is run as if it is one and the same with the person running it, the courts will consider it a sham, and will not afford the owners limited liability protection. You can read more on this topic in our article on Piercing the Corporate Veil.

Second, even in a limited liability business an owner may be responsible for amounts beyond his or her investment. This is the case when an owner has personally co-signed a debt agreement (such as a credit card application). This signature gives the lenders a personal guarantee of repayment of that debt and in the case of default they can go after the owner's personal assets. Other owners of the company (or investors) would not be liable if complete repayment is beyond the resources of the business, but the owner who had done the co-signing would be responsible for that amount.

Can anyone operate a limited liability business?

No, in some professions it is impossible to reap the benefit of limited liability. Professionals like lawyers, doctors, accountants, chiropractors, engineers, or architects are prevented by law and ethics from limiting their liability. We want these professionals to be personally responsible for their decisions so that they always make the decisions carefully.

The bottom line is, anyone doing business should consider taking advantage of a limited liability entity, if at all possible. Consider it an insurance against your worst case scenario.