Limited and Unlimited Liability

What It Means

In business, liabilities are debts that companies take on as they conduct business. It is common for businesses in the normal course of growth and activity to accumulate debts as they borrow money for new operations or expansions, purchase supplies and raw materials using credit, or take out mortgages on property or equipment. There are two general categories of liabilities: current liabilities, which are paid off within one year, and long-term liabilities, which are paid off in time frames greater than one year.

The term limited liability is used to describe a situation in which those responsible for paying back a debt are limited in the amount of money they owe in repayments. In terms of business ownership, limited liability describes a legal arrangement in which business owners are financially responsible for only the amount of money they have put into the business. For example, if the owner of a small business sets up his company with limited liability, and later the business loses so much money that it must file for bankruptcy, the owner will owe only the amount of money that he initially put into the business.

The term unlimited liability describes a situation in which those obligated for paying back a debt have unlimited responsibility to pay it back. This means that a business owner is held personally responsible for the debts of his business if the business runs out of money to pay its debts. If the business accumulates debts and then closes down or is successfully sued for a large amount of money, the owner of the business will usually have to pay out of his personal finances.

When Did It Begin?

The concept of limited and unlimited liability has developed apace with modern accounting, the growth of business, and the evolution of the modern stock market. Before the nineteenth century, incorporation (or the formation of a legal corporation) for businesses was uncommon; many businesses did not incorporate but operated as loosely organized associations. Legal issues, such as issues of debt, were often difficult to resolve because laws did not govern unincorporated businesses.

Limited partnerships were types of business organizations formed in Europe and the United States in the eighteenth and early nineteenth centuries. The liability of the owners of the business was limited to a certain extent. One partner, or owner, in a limited partnership was held entirely liable for any losses the business suffered, and other partners, or member-owners, were held liable only to the extent that they had contributed to the business.

In England two laws were passed in the middle of the nineteenth century that affected liability regulations for businesses. The Joint Stock Companies Act of 1844 permitted businesses to incorporate legally using the investment contributions of a group of individuals who became the shareholders of the company. However, the law did not limit the liability of investors. The Limited Liability Act of 1855 established the legal ability of companies to limit liability if it had more than 25 owners. Over the next several years, similar laws were passed in France and the United States. These laws played an important role in the development of large, well-funded businesses.

More Detailed Information

Liability laws play a significant role in how businesses are established and run. More than 25 million businesses operate in the United States, but there are essentially only a few different types of legal categories of businesses. These legal definitions are based on the conditions of ownership. In a sole proprietorship, a single owner possesses the business, is entitled to all of the after-tax profits, and is responsible for all of the obligations of the firm, meaning he or she has unlimited liability. Most businesses are sole proprietorships, partly because they are the easiest form of business to start.

In a partnership, the responsibilities of the firm are shared between co-owners, called general partners, of which there may be more than two. The general partners share the investment of financial and other resources as well as any profits the business generates. They also share unlimited liability for debts and obligations. This type of business arrangement is common for doctors, lawyers, and architects.

The risks of unlimited liability can be daunting to some people since it means that they stand the chance of having to use their personal resources as payment if they are sued or if their business shuts down. This compels some people to form their business as a corporation, which divides the ownership among those who buy shares of stock. The stock represents the power of the shareholder to vote for members of a board of directors of the corporation. The board of directors hires the managers of the business. One of the primary advantages of forming a corporation is the fact that the liability of the owners is limited to the amount each has paid for his or her share or shares of stock. Even if the company faces financial setbacks or goes bankrupt, the owners’ personal wealth is not vulnerable to loss.

Although unlimited liability is a feature of sole proprietorships and partnerships, it is also the primary legal feature of a company that forms as an unlimited liability company. Although this type of company is uncommon, it is an appropriate arrangement for a company that is formed only to hold land or other investments and not trade in goods or property.

The owners of a company are one source of money for businesses; businesses are also able to borrow money from banks and other financial institutions or from individual lenders. The individual who loans financial resources to a business or organization is called a creditor. Creditors loan money to organizations to earn a return on their investments. They usually loan money for a specific period of time and are promised a specific rate of return on their investments, usually a fixed rate such as 10 percent. Owners, on the other hand, typically invest their money for an unspecified amount of time (which generally lasts until they decide to sell their investments), and they receive a return that depends on the profits earned by the business.

Recent Trends

Another category of business organization, the limited liability company (LLC), has become popular in the United States since the mid-1970s. The LLC combines aspects of partnerships and corporations in an effort to maximize the advantageous aspects and minimize the disadvantageous aspects of both types of businesses. As in a partnership, the members of an LLC may be unlimited in number and are not shareholders. Instead of being required to split their profits equally between members, they may distribute their profits according to their own arrangements. The primary characteristic of the limited liability company is that, like a corporation, it is a legally separate entity from its owners, and the company’s owners cannot be held personally responsible for the business’s debts should the business not meet them. Another advantage of the limited liability company is that the Internal Revenue Service (IRS) recognizes the LLC as a separate business entity and establishes well-defined tax rules for it. The LLC does not have a charter in the same way a corporation does, and it is not required to fulfill many of the obligations of corporations. For example, an LLC does not have to have meetings or keep written records of meeting details (called minutes) or resolutions. In general, it is simpler to operate an LLC than it is a corporation.