As a business owner, you’ve likely come across the term ‘limited liability’. It’s a fundamental concept in the world of business and finance, and understanding it can make a significant difference to how you manage your company’s financial risks.
But what does limited liability mean, and how does it impact you and your company? Let’s explore this in more detail.
Understanding Limited Liability
Limited liability is a legal principle that safeguards you as a business owner from personal financial loss if your company faces financial difficulties. In essence, it limits your personal financial responsibility to the amount you’ve invested in your company.
For instance, if your business fails or is sued, the amount of money for which you are personally liable is limited by your business structure. This ‘safety net’ can take several forms, depending on the type of business structure you’ve chosen.
Types of Limited Liability Structures
There are several types of business structures that offer limited liability. Each has its own unique features, advantages, and disadvantages.
Private Limited Company (Ltd)
A private limited company, or Ltd, is the most popular business structure in the UK.
Once established, the company is a separate legal entity with finances that are separate from yours. This means that, in the event of liquidation or litigation, you can only be personally liable for the face value of your share in the business. Any further liability must be paid out of the company’s assets.
Advantages of a private limited company include:
- Protection of your personal assets
- Lower corporation tax rate compared to income tax
- The ability to operate with just one member
- The company can perform actions such as opening its own bank accounts, buying property & assets, investing and taking out insurance, all in its own name
- The ability to issue shares, which can be an effective way of raising capital
- The company can retain profits into future tax years
- The company has an independent existence from you, so it can be sold or passed on
However, there are also potential disadvantages:
- Reduced control – other shareholders may dispute your decisions
- The company can’t trade shares to the general public
- More complex accounts, for which you’ll likely need an accountant
- The company’s accounts will be made public
- You will need to work out how to take an income from the company
Public Limited Company (Plc)
A public limited company (Plc) is similar in most respects to a private limited company. The main differences are:
- Shares in a Plc are traded on the stock market and can be bought and sold by anyone
- A Plc must have share capital of at least £50,000
- A Plc must have at least two directors, plus a company secretary
The main additional advantage of a Plc is being able to raise more capital from trading shares, while the main downside is the additional scrutiny the company will face.
Limited Liability Partnership (LLP)
A limited liability partnership (LLP) works in a similar way to an ordinary partnership, except that the partners are not liable for each other’s actions. In an LLP, the individual partners cannot lose more than they have invested in the LLP (except in cases of fraud or wrongful trading).
Advantages of an LLP include:
- Protection from errors made by fellow partners
- The LLP can enter into contracts in its own name
- The structure of an LLP can be more flexible than that of a limited company
- You can protect the partnership’s name
However, there are also potential drawbacks:
- You need to register with Companies House and submit annual accounts
- The LLP’s accounts will be made public
- Setting up an LLP can be more complex than setting up a traditional partnership
The Concept of Unlimited Liability
To fully appreciate the benefits of limited liability, it’s helpful to understand its opposite: unlimited liability.
In an unlimited liability business structure, such as a sole proprietorship or a general partnership, the owners are personally responsible for all the business’s debts.
This means that if the business can’t pay its debts, the owners must do so out of their personal assets. This could include their homes, cars, savings, and other assets.
In contrast, with limited liability, your personal assets are generally protected if your business runs into financial trouble.
The Differences Between a Company Director and a Sole Trader
Limited Liability of Company Shareholders
In a limited company, the shareholders’ liability is limited to the nominal value of their shares. The nominal value is the face value of the shares when they were issued, not their market value.
For example, if you own 100 shares in a company, each with a nominal value of £1, your total liability is £100. If the company goes bankrupt, you won’t be required to contribute more than this amount towards its debts.
This protection is one of the key advantages of investing in limited companies. It allows investors to participate in a company’s growth and profits without risking more than their initial investment.
Limited Liability of Company Guarantors
In a company limited by guarantee, the members act as guarantors rather than shareholders. This type of company structure is often used by non-profit organisations, clubs, and charities.
The guarantors agree to contribute a predetermined amount towards the company’s debts if it goes into liquidation. This amount is typically quite small, often just £1. Beyond this, the guarantors have no further liability.
Limited Liability of Company Directors
As a director of a limited company, you enjoy the same limited liability protection as shareholders. This means that if the company goes into financial trouble, your personal assets are generally safe.
However, there are exceptions. Directors can be held personally liable if they act fraudulently or negligently, fail to keep proper accounting records, or continue to trade when the company is insolvent. In these cases, directors can be held personally liable for the company’s debts and may also face disqualification, fines, or even imprisonment.
In addition, where company borrowing is needed, via a bank loan, commercial mortgage or SPV mortgage, the bank will often ask the directors for a personal guarantee (PG). This improves the banks position as it derisks the borrowing. But it does mean that the directors who have given a PG are now personally liable for that loan/facility.
Exceptions to Limited Liability Protection
While limited liability offers significant protection, it’s not absolute. There are situations where the ‘corporate veil’ can be lifted, and you can be held personally liable for your company’s debts. These include:
- Fraudulent trading: If you’re found to have carried on business with the intent to defraud creditors, you can be held personally liable.
- Wrongful trading: If you continue to trade when you know (or should know) that there’s no reasonable prospect of avoiding insolvent liquidation, you can be held personally liable.
- Personal guarantees: If you’ve personally guaranteed a loan or other debt for your company, you’ll be personally liable if the company can’t repay it.
- Overdue taxes: Directors can be held personally liable for certain unpaid taxes if they fail to meet their obligations.
Limited Liability and Sole Traders
As a sole trader, you don’t enjoy the same limited liability protection as a limited company. This means that if your business runs into financial trouble, your personal assets could be at risk.
However, there are ways to limit your liability as a sole trader. For example, you could consider taking out insurance to protect against certain risks, or you could look at restructuring your business as a limited company or LLP.
Limited Liability and Insolvency
If your company becomes insolvent, the limited liability structure protects your personal assets from being used to pay off the company’s debts. However, as mentioned earlier, there are exceptions to this rule.
If you’re facing insolvency, it’s essential to seek professional advice as soon as possible. An insolvency practitioner can help you understand your options and guide you through the process.
Limited Liability: Limited by Shares vs Limited by Guarantee
Finally, it’s worth noting the difference between companies limited by shares and companies limited by guarantee.
In a company limited by shares (the most common type of limited company), the shareholders’ liability is limited to the nominal value of their shares.
In a company limited by guarantee, there are no shareholders. Instead, the members act as guarantors and agree to contribute a predetermined amount towards the company’s debts if it goes into liquidation.
Understanding limited liability is vital for any business owner. It’s a key factor in choosing the right business structure and can significantly impact your personal financial risk.
Remember, while limited liability offers significant protection, it’s not absolute. There are situations where you can be held personally liable for your company’s debts. Therefore, it’s always a good idea to seek professional advice when setting up a business, facing financial difficulties, or considering changing your business structure.
In the world of business, knowledge is power. The more you understand about concepts like limited liability, the better equipped you’ll be to make informed decisions that can help protect your personal assets.
Whether you’re a sole trader considering transitioning to a limited company, a director of a company facing financial difficulties, or an investor looking to understand the risks of your investments, understanding the ins and outs of limited liability can be a game-changer.
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