What Is Limited Liability?

Limited liability is a type of legal structure for an organization where a corporate loss will not exceed the amount invested in a partnership or limited liability company. In other words, investors' and owners' private assets are not at risk if the company fails. In Germany, it's known as aftungHeschränkter bit mesellschaft G.

The limited liability feature is one of the biggest advantages of investing in publicly listed companies. While a shareholder can participate wholly in the growth of a company, his or her liability is restricted to the amount of the investment in the company, even if it subsequently goes bankrupt and has remaining debt obligations.

[Important: limited liability allows for other legal innovations such as bankruptcy protection and the classification of firms as juridical persons.]

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Limited Liability

How Limited Liability Works

When either an individual or a company functions with limited liability this means that assets attributed to the associated individuals cannot be seized in an effort to repay debt obligations attributed to the company. Funds that were directly invested with the company, such as with the purchase of company stock, are considered assets of the company in question and can be seized in the event of insolvency.

Any other assets deemed to be in the company’s possession, such as real estate, equipment, and machinery, investments made in the name of the institution and any goods that have been produced but have not been sold, are also subject to seizure and liquidation.

Without limited liability as a legal precedent, many investors would be reluctant to acquire equity ownership in firms, and entrepreneurs would be wary of undertaking a new venture. This is because without limited liability if the company loses more money than it has, creditors and other stakeholders could claim the investors' and owners' assets. Limited liability prevents that from occurring, and so the most that can be lost is the amount invested, with any personal assets held as off-limits.

Key Takeaways

  • Limited liability is a legal structure of organizations such as firms that limit the extent of an economic loss to assets invested in the organization and which keeps personal assets of investors and owners off-limits.
  • Without limited liability as a legal precedent, many investors would be reluctant to acquire equity ownership in firms and entrepreneurs would be wary of undertaking a new venture.
  • Several limited liability structures exist such as limited liability partnerships (LPs and LLPs), limited liability companies (LLCs), and corporations.

Limited Liability Partnerships

In a partnership, the limited partners (LPs) have limited liability while the general partner has unlimited liability. The limited liability feature protects the partner's personal assets from the risk of being seized to satisfy creditor claims in the event of the company's or partnership's insolvency while the general partner’s personal property would remain at risk.

Another advantage of an LLP is the ability to bring partners in and let partners out. Because a partnership agreement exists for an LLP, partners can be added or retired as outlined by the agreement. This comes in handy as the LLP can always add partners who bring existing business with them. Usually, the decision to add requires approval from all the existing partners.

Overall, it is the flexibility of an LLP for a certain type of professional that makes it a superior option to an LLC or other corporate entity. Like an LLC, the LLP itself is a flow-through entity for tax purposes. This means that the partners receive untaxed profits and must pay the taxes themselves. Both an LLC and LLP are preferable to a corporation, which is taxed as an entity, and then its shareholders are taxed again on distributions.

The actual details of a limited liability partnership depend on where you create it. In general, however, your personal assets as a partner will be protected from legal action. Basically, the liability is limited in the sense that you will lose assets in the partnership, but not those outside of it (your personal assets). The partnership is the first target for any suit, although a specific partner could be liable if he or she personally did something wrong.

Limited Liability in Incorporated Businesses

In the context of a private company, becoming incorporated can provide its owners with limited liability since an incorporated company is treated as a separate and independent legal entity. Limited liability is especially desirable when dealing in industries that can be subject to massive losses, such as insurance.

A limited liability company (LLC) is a corporate structure in the United States whereby the owners are not personally liable for the company's debts or liabilities. Limited liability companies are hybrid entities that combine the characteristics of a corporation with those of a partnership or sole proprietorship.

While the limited liability feature is similar to that of a corporation, the availability of flow-through taxation to the members of an LLC is a feature of partnerships. The primary difference between a partnership and an LLC is that an LLC separates the business assets of the company from the personal assets of the owners, insulating the owners from the LLC's debts and liabilities.

As an example, consider the misfortune that befell numerous Lloyd's of London Names, who are private individuals that agree to take on unlimited liabilities related to insurance risk in return for pocketing profits from insurance premiums. In the late 1990s, hundreds of these investors had to declare bankruptcy in the face of catastrophic losses incurred on claims related to asbestosis.

Contrast this with the losses incurred by shareholders in some of the biggest public companies to go bankrupt, such as Enron and Lehman Brothers. Although shareholders in these companies lost all of their investment in them, they were not held liable for the hundreds of billions of dollars owed by these companies to their creditors subsequent to their bankruptcies.