Limited Liability Definition: How It Works in Corporations and Businesses (2024)

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 (LLC). In other words, investors' and owners' private assets are not at risk if the company fails. In Germany, it's known as Gesellschaft mit beschränkter Haftung (GmbH).

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, their liability is restricted to the amount of the investment in the company, even if it subsequently goes bankrupt and has remaining debt obligations.

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 creditors and other stakeholders could claim the investors' and owners' assets if the company loses more money than it has. Limited liability prevents that from occurring, so the most that can be lost is the amount invested, with any personal assets held as off-limits.

Limited Liability Partnerships

The actual details of a limited liability partnership depend on where it is created. 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 assets outside of it (i.e., your personal assets). The partnership is the first target for any lawsuit, although a specific partner could be liable if they personally did something wrong.

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 new partners 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 many other corporate entities. The LLP itself is a flow-through entity for tax purposes, which is also an option for LLCs. With flow-through entities, the partners receive untaxed profits and must pay the taxes themselves.

Both LLCs and LLPs are usually preferable to corporations, which are impacted by double taxation issues. Double taxation occurs when the corporation must pay corporate income taxes, and then individuals must pay taxes again on their personal income from the company.

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.

An 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 apartnershipand an LLC is that an LLC separates the business assets of the company from the personal assets of the owners, insulatingthe owners from the LLC's debts and liabilities.

As an example, consider the misfortune that befell numerous Lloyd's of LondonNames, 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 that went bankrupt, such as Enron and Lehman Brothers. Although shareholders in these companies lost all of their investments 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.