Limited Liability in accounting refers to the concept of the legal structure of an organization that differentiates the owner’s other personal assets from those invested in the company. In other words, it restricts the owner’s liability to the extent of the capital contributed to the business and their personal assets will NOT be at risk in case the company fails to perform.
Let us understand the concept of limited liability with a simple example. Suppose that an investor, James invests $1,000 in a Limited Liability Company (LLC), and his remaining net worth, including a home and a shop, totals $300,000. After a few months, James finds out that the company has gone bankrupt.
Despite selling all the assets to pay the debt of the company, the court values the remaining liability at $300,000. Now, we and the court knows that James has the $300,000, and the company’s debt could be paid off by selling James’ assets. Luckily for James and all other shareholders, this isn’t an option because the company was operated under limited liability which means James, in the worst-case scenario can lose his $100,000 only.
Take that example with a sole proprietorship or unlimited liability partnership and James and other investors would have been responsible for the business’ debt and their liability would have expanded beyond their capital in the business.
Primary Difference Between Limited And Unlimited Liability
A business with limited liability is considered a purely different entity from its owners. That means both the business and owners are separate entities responsible for their own actions. The worst an owner can suffer is losing his capital invested in the business.
In unlimited liability, the business and owners are legally considered a single entity. Owners are responsible for the debts and other payables of the business and upon failure of the business, the court can order to sell the owner’s personal assets to pay the business’ debts.
Advantages Of Limited Liability
- Protects the owners’ personal assets because it is a separate entity and the owners are not responsible for capital beyond their investment, meaning that it places a cap on the owner’s loss.
- The operating style of the business is precise and everything including rewards and returns is determined by written agreements.
- A limited liability company or limited liability partnership has greater flexibility in terms of operating the business. The owners need not participate in the business activities.
- A limited liability company is considered as a separate entity and can buy, rent or lease properties.
- It reduces taxes for members through lower dividend rates. Eg: In the UK, income tax rates are 20%, 40%, and 45% for basic, higher, and additional rate bands whereas dividend rates are 7.5%, 32.5%, and 38.1% respectively. (For Tax Year 2021/2022)
Article Sources
- https://www.sec.gov/reportspubs/investor-publications/investorpubsbankrupthtm.html
- https://www.jstor.org/stable/1599572?seq=1
- https://www.gov.uk/tax-on-dividends
