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Limited liability is a legal status that limits a person’s financial responsibility for the debts of a business to a fixed sum. It is an important characteristic of incorporated business structures that exist as distinct legal entities, including limited companies, limited liability partnerships, and limited partnerships.
If you are thinking about starting your own business and you’re wondering which structure is best to use, it’s important for you to understand the concept of limited liability, what it means in practice, and how it compares to unlimited liability.
Limited liability in a limited company
Limited companies can be set up with or without share capital. Those with share capital are limited by shares, whereas companies without share capital are limited by guarantee.
The members of a limited company benefit from the protection of limited liability. In a limited by shares company, the members are known as shareholders. In a limited by guarantee company, the members are known as guarantors.
The liability of shareholders is limited to the unpaid portion (if any) of the nominal value of their shares. Typically, the nominal (par) value of a share is just £1. Therefore, if a shareholder takes 10 shares, for example, their total liability is capped at £10.
Guarantors do not own shares because limited by guarantee companies do not issue shares. Instead, guarantors each prove a ‘guarantee’, which is a legal promise to pay the company a fixed amount of money if it cannot pay its debts or is wound up. Most guarantees are a nominal sum of just £1.
Beyond the limited liability of members, companies are responsible for their own debts and liabilities. Creditors cannot recover debt from the personal assets of the members or directors – they can only claim from the assets of the business.
This is because limited companies exist as legal entities separate from their members and directors. However, there are exceptions to limited liability, which we discuss later in the post.
When do members pay the nominal value of their shares or guarantees?
Shareholders often pay the nominal value of their shares as soon as they agree to take them. This may be during the company formation process or after incorporation.
However, each company has its own rules on paying for shares. These rules are set out in the articles of association and/or a shareholders’ agreement.
Some companies allow shares to be held unpaid or partly paid until a specified future date or the director issues a ‘call on shares’. When a company issues a call notice, members are required to pay some or all of the outstanding sum that they owe on their shares.
In a limited by guarantee company, the guarantors will pay the agreed sum stated in their guarantees when the company director asks them to do so. This will usually happen if the business is insolvent and has to be wound up (closed).
If a company becomes insolvent (i.e. bankrupt), the capital raised from the nominal value of shares or guarantees contributes toward paying off its outstanding debts during the liquidation process.
Limited liability in a limited liability partnership (LLP)
Limited liability partnerships (LLPs) do not have shares. They are set up by two or more LLP members, who are the partners in the business and each has limited liability for the debts and actions of the LLP.
The financial liability of LLP members for any outstanding business debts upon the winding up of the partnership is limited to the amount of capital they invest in the business and/or any personal guarantees they provide.
Liability of partners in a limited partnership (LP)
Limited partnerships (LPs) and Scottish limited partnerships (SLPs) have both limited partners and general partners.
Limited partners enjoy limited liability. They are only liable for debts of the partnership up to the amount of money or value of property they contribute to the business.
General partners, on the other hand, are personally liable for any business debts that the partnership itself is unable to pay.
In exchange for assuming greater financial risk, general partners control and manage the business and have the power to make binding decisions on behalf of the entire partnership.
Exceptions to limited liability of members and limited partners
In certain circumstances, limited liability does not apply to company members, LLP members, and limited partners. This situation is known as ‘lifting’ or ‘piercing’ the corporate veil – a theoretical barrier that separates the legal personalities of the person and the business.
A person with limited liability protection may be held personally responsible for the debts of their business, if they provide a personal guarantee for a business loan and the company or partnership is unable to repay it.
LLP members, limited partners, and company members who are also directors, may lose the benefit of limited liability in the following situations:
- Continuing to trade whilst knowing that the business is insolvent
- Disposing of business assets for free or below market value during insolvency
- Engaging in fraudulent or illegal activities
- Mismanagement of business finances
- Misapplication of assets belonging to the business
- Having an overdrawn balance in a director’s loan account
- Issuing illegal dividends in a company limited by shares
- Evading tax
- Breaching health and safety duties
Where the corporate veil is lifted, creditors and claimants can hold individuals personally liable for the debts of the business, make claims on their personal assets (e.g. property, savings, investments), and use those assets to recover payments owing to them.
Minimising your exposure to personal liability
As a business owner or company director, it is important to be aware of the financial risk and take steps to limit your exposure to personal liability for the debts of your company or partnership.
Whilst it is not always possible to remove all personal risk in business, there are several things you can do to minimise the potential for personal liability.
Irrespective of the type of business structure you use, you should keep finances separate by setting up a business bank account. This will help you to avoid any accidental misappropriation of company or partnership funds for personal use.
Similarly, when you enter into contracts on behalf of your business, care should be taken to ensure all documents are drafted and executed correctly.
Unless you are choosing to provide a personal guarantee for a business loan, you should not sign contracts using only your name. Ensure the documentation makes clear that you are providing your signature ‘on behalf of’ the business.
Appointing an accountant and consulting a solicitor, where applicable, will also help to minimise your exposure to personal liability.
An accountant can help you to manage your business finances appropriately and provide specialist tax advice, whilst a solicitor will be able to advise on matters such as client and supplier contracts, personal guarantees, shareholders’ agreements, and LLP agreements.
You can further protect your personal finances by taking out business insurance, such as employers’ liability, public liability, professional indemnity, and directors and officers’ (D&O) liability insurance policies.
What is unlimited liability?
In stark contrast to limited liability protection, having unlimited liability means that a person’s financial liability is not capped at a certain amount. There is no limit to how much money the person can be held liable for if their business fails or is sued.
Sole traders, general members of limited partnerships, and partners in general business partnerships have unlimited liability for business debts and claims. There is no legal separation between the person and the business in terms of liability.
Consequently, creditors and other third parties to whom the business owes money can make claims on the person’s personal assets. This means that all of their personal assets, including their home and savings, are at risk if the business cannot pay its debts. In serious cases, it can lead to personal bankruptcy.
Despite the lack of financial protection, business structures with unlimited liability are popular and suitable for many types of people. It depends entirely on the type of work the business does and the needs of the owner(s).
If you are unsure which business structure is best for you, we recommend talking to an accountant or independent business advisor. They will be able to provide tailored advice and help you to make an informed decision.
So, there you have it…
We’ve explained the concept of limited liability as it relates to incorporated business structures, what it means in practice, the situations where this protection may not apply, and how it compares to unlimited liability.
Hopefully, you now have a clear understanding of the meaning of limited liability and why it is such an important consideration when starting a business or getting involved with an existing limited company, LLP, or LP.
If you have any questions about this topic, or you would like to know more about setting up a limited company or limited liability partnership, please leave a comment below or contact our team of company formation experts.