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What Does "Limited Liability" Mean to a Business Owner?

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Question: What Does "Limited Liability" Mean to a Business Owner?
Answer:

The "Limited Liability" Concept
The term "limited liability" has been around since the formation of corporations. In the U.S., Corporations were formed in part because the owners of the corporation didn't want to be held liable for actions of the business. The term "limited liability" has been extended to the newer form of business organization, the limited liability company. But what does "limited liability" really mean? Common misunderstanding assumes that limited liability means that business owners are not liable for anything that happens in the business, but this is not true. "Limited liability" does not mean "no liability," and business owners can be held liable in some circumstances.

When business owners may have liability
For these examples, you can assume that the same circumstances apply for corporations and for LLC's (limited liability companies) and some limited partnerships. In general, Business owners may be liable for the actions of the business in four different circumstances:

  • The business owner is personally liable If the owner is negligent, or commits fraud or some other illegal action. For example, if you defraud customers, the liability protection of the company won't protect you. Or if you have a professional business and you injure a client, you can't hide behind the company's liability protection. In the case of professional misconduct, you should have malpractice insurance or other professional liability insurance.

  • When the owner personally guarantees a contract. In some circumstances, a business owner must personally guarantee a business contract; in this case, the personal liability of the owner to fulfill the contract overrides the "limited liability" circumstances. The best example of this situation is when a business owner must personally guarantee a loan to the business with personal assets. If the business cannot make the loan payments, the business owner is personally responsible for these payments and must pledge personal assets to pay off the loan.
    A business owner should make sure that he or she does not personally sign a contract which should have been signed on behalf of the business. The corporation or LLC is the party to the contract, not the individual. If the owner signs as an individual, he or she has assumed the liability for that contract.

  • Actions that "pierce the veil" of the corporation. This concept is somewhat difficult to define, but it is important to the concept of limited liability. In general, if the corporation or LLC is considered completely separate from the individuals who own and manage the business, those owners/managers cannot be held responsible for the company's actions. The company and individuals are separate. But if the individuals act in a way that dissolves (or appears to dissolve) this separation, the "corporate veil" between the company and the individuals has been "pierced" and now the actions of the individuals are no longer separately considered. In this case, one action by shareholders or LLC members can cause other actions to be considered in weighing liability.
    Some of the most common actions which pierce the corporate veil are:
    • Co-mingling funds (that is, not keeping business and personal funds separate)
    • Diverting business assets for personal use without proper documentation (in the case of a loan to a shareholder or offer, for example)
    • Failing to keep corporate (or LLC) records
    • Officers or directors not functioning in these capacities
    Circumstances and laws are different in various states and jurisdictions, but it's not unusual for corporate directors or LLC members to be held liable for actions if the veil between the company and the owners has been pierced.
There are other actions which can cause "limited liability" to be waived by the courts or not considered in a lawsuit, such as receiving distributions not allowed by the state where the business is located, but the circumstances above are the most common.

How to maintain "limited liability" protection

It is not always possible to avoid some circumstances that may invalidate or cancel limited liability protection, but there are some measures you and other owners of your business can take to maintain limited liability protection:

  • Avoid actions that will be charged as negligence, fraud, or other criminal acts. Sure, you may not have complete control of other corporate shareholders or officers or other LLC members, but monitoring each other and sharing information on possible issues may help keep you out of such lawsuits.
  • Keep excellent corporate and LLC records. Don't assume that having an LLC rather than a corporation absolves you of the responsibility to keep records. Record all meetings and actions of the board and LLC membership.
  • Don't mix business and personal funds.
  • If one of the owners takes money from the business, be sure to record this as either a loan or a disbursement and include the proper documentation of the transaction. A loan to the business or capital contribution should also be recorded and the transaction appropriately documented.
  • Get the advice of your attorney to make sure you are not doing anything that could be considered as "piercing the corporate veil."

Disclaimer. The information in this article, and on this GuideSite, is intended to be general in nature. The author is not an attorney, CPA or tax professional, and does not intend to give legal advice. Every situation and location is different. Questions about the information in this article should be discussed with your tax or legal advisor before you take any actions.

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