The Nature of Limited Liability

April 13, 2006

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When choosing an organizational form for your business, one of the important considerations involves the concept of limited liability. Only in the corporation and LLC form do all of the owners enjoy full "limited liability" in every state. But what, exactly, is limited liability?

It is sometimes mistakenly said that a corporation or LLC has limited liability. In fact, the corporation and LLC have unlimited, personal liability for their debts. They can lose everything they own.

It is the owners who enjoy limited liability: The owner's liability for the business's debts is limited to what he or she has invested in the business (i.e., the business's assets).

The business can lose everything it owns, and this includes the owner's investment in the business. It is wise, therefore, to invest and maintain as little capital as possible within the business form. This tenet of asset protection may be carried out in a number of different ways, through effective asset exemption planning, proper entity choice, strategic funding and structuring, and careful planning of day-to-day operations. Because of limited liability, of course, the owner's personal assets, outside of the business form, are shielded from liability for business debts.

Let's say the owner of a sole proprietorship or a general partnership has a personal net worth of $1 million, outside of his business, as well as outside of post-judgment and bankruptcy exemptions. His business suffers severe financial difficulties, resulting in a debt of $1.5 million, due to a loss of market share, default on loans, loss of a major lawsuit, etc.

Further, if the owner, at the time of the loss, has $2,000 invested in the business. What does the owner stand to lose? His entire personal net worth of $1 million, in addition, of course, to his $2,000 business interest.

Now if the owner had been operating his business as a corporation or LLC, due to limited liability, his loss now would be limited to his investment in the business, $2,000, and his entire personal net worth of $1 million would be preserved.