Limited liability is the extent to which a company shareholder or director is financially responsible for their company’s debts.
To benefit from limited liability, a business must be incorporated at Companies House to become a private limited company (LTD), public limited company (PLC) or limited liability partnership (LLP).
Once it has been incorporated, the business becomes a separate legal entity from its owners. That means the finances and assets of the individual and the finances and assets of the company are completely separate.
If the company is sued or cannot pay its debts, the owners are only liable for the debt to the value of the money they have already invested in the business
What does ‘limited liability’ mean?
In business, limited liability is about reducing your personal exposure to financial risk. If your business fails (or is sued) then the amount of money for which you are liable is limited by the business structure. There are a number of different forms that this ‘safety net’ can take.
Limited liability means that the directors or shareholders are only responsible for business debts up to the value of their financial investment in the business. This means that a creditorcan only take assets or finances belonging to the company. Limited liability only applies to certain types of business, such as private limited companies.
The same rule goes for legal action. Should someone sued the company, it is the legal structure that is the company which is being sued, not the individuals involved.
Shareholders can only lose (are therefore liable for) the value of their investment in the share capital of the company. However, limited liability does not protect against wrongful or fraudulent trading or when directors give personal guarantees.
What is limited liability in business
Limited liability is a legal concept that protects a business’s owner(s) from being personally liable for the company’s debts and obligations. This means that if the company is sued or goes into debt, the owner’s personal assets, such as their home or savings, cannot be taken to pay off the debts.
Corporations, limited liability companies (LLCs), and limited liability partnerships are all examples of business structures that have limited liability. It is a crucial aspect of business law that promotes entrepreneurship by limiting potential risks and financial losses that business owners may face.
Limited by shares vs limited by guarantee
Company incorporation is an important process for any business, large or small. One of the first steps in this process is to choose the type of company structure that best suits your business. In the UK, there are two main types of limited companies: those that are limited by shares and those that are limited by guarantee. Limited by shares companies are owned by shareholders, who have limited liability in the event of the company’s insolvency.
Limited by guarantee companies, on the other hand, are owned by guarantors who agree to cover the company’s debts up to a certain amount should it become insolvent. While both types of company offer limited liability protection for their owners, there are some key differences between them that you should be aware of before making your choice. Limited by shares companies may be better suited to businesses that are looking to raise investment capital, as they can offer shareholders a share in the company’s profits. Limited By Guarantee companies, on the other hand, may be better suited to non-profit organisations or businesses with a more social purpose, as they tend to have a more defined Membership criteria.
Ultimately, the decision of which type of company to incorporate as will come down to your specific business needs and objectives. Whichever route you choose, make sure you seek professional advice to ensure you are making the best decision for your business.
How does limited liability work?
In order to get limited liability, a company must be incorporated at Companies House and registered as a limited company. The business can be registered as a private limited company, a public limited company, or a limited liability partnership; so long as the company is incorporated, limited liability will be given to its directors and shareholders. Limited liability also applies if the company is limited by shares or limited by guarantee; while the type and structure may be different, limited liability is still granted.
Once a company is incorporated it is classed as its own legal entity, separate from its directors. This means the company is responsible for any borrowing it takes out, rather than its shareholders. This also applies if the company is threatened with litigation at any point; it is the company which is being sued, not its directors.
When can a director be held liable for company debts?
Losing the protection of limited liability is sometimes called “piercing the corporate veil.” In other words, the loss of liability opens up the owner to full liability. The owner of a business can lose limited liability protection in several different circumstances;
Misuse of funds. If a business owner takes business funds for personal use, or if the owner commingles funds for his or her own gain. For example, if the owner has mixed both business and personal funds in a personal checking account and doesn’t clearly separate the two types of funds, this may result in misuse of the funds.
Conflict of interest. A conflict of interest happens when the duties of a person in a fiduciary position has competing personal and business responsibilities or loyalties. If the person lets personal interest come before the fiduciary position, that’s a conflict of interest. An example of a conflict of interest would be if a board member of Company A has a personal construction business and the construction business gets the bid to build a development, even if that deal wouldn’t be best for Company A.
Fraud. Fraud is knowingly misrepresenting something for material gain. For example, if a business owner defrauds customers by concealing the defects in a product or commits insurance fraud by overvaluing assets, the liability protection of the company won’t protect the owner. Fraud is a breach of the duties and responsibilities of a business owner, and it is against the law.
Criminal action. If the owner of a business or an employee assaults a customer, the business 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.
Personal guarantees. 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.
Advantages of a Limited Liability Company?
There are a number of advantages associated with a limited liability company. Here a few great benefits of setting up a limited company and here they are:
Tax efficient
It’s well known that a limited company is more likely to be tax efficient compared to a sole trader, and that is one of the many reasons it’s a popular business model. A limited company director will usually take the maximum amount that is not being taxed in the tax year. For example, for the tax year 2020/21 this sum is £12,500. More on tax rates here. Then the remainder of the income is taken through dividends. Dividends are great as you don’t have to pay NIC’s (National Insurance Contributions) on the dividedness. Dividends are also taxed on the lower rate of income tax than self-employment incomes.
Companies also have to pay the 19% corporation tax on profits, this is opposed to the 20-45% incomes tax that sole traders have to pay on their profits.
Separate entity
In the eyes of the law, a limited company business is a separate entity to its owner. This is another great benefit of setting up a limited company, rather than a sole trader. A sole trader and its owner are seen as one entity. A limited company director has the protection, should the business fail. As the company is the separate entity, it can enter into contracts and is liable for all the business actions. A limited company director will have no attachment to the company’s actions apart from their share of the company.
Professional status
When a business is set up as a sole trader, the business is not officially registered with the Companies House. This makes the process easier, however, anyone can use your name for their business and you will have no right to take action against this (unless you get it trademarked). When you register your business with the Companies House, you trademark your business name so no other business can use it. This makes your business individual and it can also help it to be found easily online.
Additionally, limited companies have more prestige when it comes to the business image. Limited companies also can come across bigger than they are, making them appear professional. It also means that a limited company is more likely to attract clients and investors than other business structures. It might even be easier for limited company directors to get funding such as loans from banks, as they are seen as a secure business.
Company pension
As an owner of the limited company, the director can invest pre-tax sum into a company pension scheme. This means that the director can save money instead of taking money out and investing it in a personal pension scheme, which will be subjected to both business and personal tax.
Maximising tax-free income
A limited company will allow you to maximise tax-free income, by having your husband/wife/partner and children shareholders. This will mean that each person can take the tax-free salary of £12,500 (as of the tax year 2020/21). For example, if a husband and wife take salary up to the amount of the tax-free income, they can accumulate £25,000 all tax-free. This is a great benefit of having a limited company, working your way around tax and maximising your income.
Conclusion
Limited liability is an important aspect of business law that helps to protect business owners’ personal assets from being seized to pay off the company’s debts and obligations. This legal concept promotes entrepreneurship by limiting the financial risks that business owners may face, and it is applicable to a variety of business structures such as corporations, limited liability companies (LLCs), and partnerships.
Limited liability is an important aspect of the business environment that contributes to the creation of a stable and supportive environment in which business owners can operate.
With over three decades of experience in the business and turnaround sector, Steve Jones is one of the founders of Business Insolvency Helpline. With specialist knowledge of Insolvency, Liquidations, Administration, Pre-packs, CVA, MVL, Restructuring Advice and Company investment.