Limited liability (corporate law)
Limited liability in corporate law refers to a legal structure that protects the personal assets of a company's members from being used to satisfy the company's debts or liabilities. Typically, individuals within a limited liability company (LLC) or limited liability partnership (LLP) are only responsible for their investment in the business, meaning their personal assets are not at risk if the company faces financial difficulties. This concept has roots in ancient practices, such as those of the Romans and early Islamic law, and was more formally codified in modern times, with the first official LLC established in Wyoming in 1977.
The limited liability structure offers several advantages, including financial protection, flexibility in income and expense distribution, and favorable tax treatment, as LLCs are generally not taxed at the corporate level. However, there are drawbacks, such as restrictions on the lifespan of the LLC, typically limited to about thirty years, and complexities surrounding the transfer of ownership. Additionally, while the federal government may not tax LLCs, some states impose taxation on their earnings. Overall, limited liability is an important aspect of corporate law that helps encourage investment and entrepreneurship by safeguarding personal financial security.
Limited liability (corporate law)
In corporate law, limited liability protects a company's investing members by limiting losses they may incur as a result of the company's decisions or actions. Usually, an individual member is liable for only his or her capital investment in the company; his or her personal assets are exempt. A company organized according to a limited liability structure often has "LLC" (limited liability company), "LLP" (limited liability partnership), or "Limited" in its name. In the United States, the first official LLC formed in the state of Wyoming in 1977, but historians trace the origins of limited liability arrangements back to the ancient Romans. The limited liability structure has both benefits and drawbacks.
Overview of LLCs
A limited liability company, or LLC, typically has two or more owners, or members, who invest in the business. Each member is liable for only the amount he or she invests in the business. For example, if the LLC defaults on a loan, creditors may sue the LLC for payment. If the LLC does not have enough assets to pay them in full, however, the creditors cannot, under most circumstances, sue the members of the LLC for the difference. Members may lose the capital they had invested in the LLC originally, but their personal assets remain protected.
Registration and regulation of LLCs occur at the state rather than federal level and therefore vary. In general, states require an LLC to have a unique name that identifies it as a limited liability company—for example, by adding "LLC" to the end of the company's name. Although many states do not require it, most recommend creating an operating agreement for an LLC. An operating agreement typically describes an LLC's organizational structure, financial operations (for example, distribution of income and expenses among members), and rules and regulations. Most states require an LLC to set a time limit on how long it may exist or establish guidelines for handling a member's departure. Other licenses, permits, and regulations vary from state to state.
History of Limited Liability
Although the first official LLC did not appear in the United States until 1977, the concept of limited liability has existed since ancient times. For example, ancient Romans relied on the peculium to limit liability. The peculium comprised assets or property given to a slave or child by the paterfamilias, or the male head of a household. The child or slave could use the peculium as if it were his own. For example, a slave might use assets in his peculium to engage in commercial trade. If, however, the slave incurred a debt that he could not pay, the paterfamilias was responsible for only the amount in the peculium and nothing more.
Early Islamic law employed a similar method. A master gave permission to a slave to operate a commercial enterprise. Responsibility for the enterprise belonged solely to the slave. If the slave incurred a debt that he could not pay, the master was not legally responsible for the debt, but the master could sell the slave to satisfy the debt.
Sea traders in Italy in the eleventh century relied on a form of limited liability known as the commenda. The commenda was a type of partnership involving an investor, known as the passive partner, and another person, known as the traveling partner. The passive partner provided the money that the traveling partner needed for an overseas business venture, and the two split the profits. In most cases, the people who dealt directly with the traveling partner had no idea that the passive partner even existed, thus limiting the passive partner's liability in any transactions.
More modern iterations of limited liability can be traced back to Germany in 1892. That year, Germans passed a law that allowed for the creation of a Gesellschaft mit beschränkter Haftung (GmbH), or company with limited liability. This model, known for its organizational flexibility, was quickly adopted by other countries in Europe and elsewhere.
In the United States, various forms of limited liability have existed since the nineteenth century. For example, a New York state law from 1811 granted limited liability to manufacturers. However, the first official LLC was not created until 1977, when the state of Wyoming passed the Limited Liability Company Act. The law became the template for additional LLC legislation in other states. By 1996, all fifty states had enacted legislation regarding the formation and regulation of LLCs.
Benefits and Drawbacks
The key benefit of the limited liability structure is the financial protection it provides to company members, but LLCs have other advantages as well. For example, members have a great degree of flexibility in determining how to distribute and share income and expenses. Because LLCs do not follow a rigid corporate structure, they require less extensive recordkeeping and often have lower start-up costs. Another advantage is tax status. The Internal Revenue Service (IRS) considers members of an LLC to be self-employed; therefore, the LLC itself does not have to pay federal taxes on its income. Instead, the IRS collects an LLC's taxes through the personal income taxes of its members.
While the limited liability structure is advantageous in many ways, it also has some drawbacks. A major drawback is the time limit on its existence. Most LLCs have a maximum life span of thirty years. In the event that a member decides to leave, goes bankrupt, or passes away, many states require the LLC to satisfy any outstanding obligations and then close. Transferral of ownership for LLCs is quite complicated. Additionally, even though the federal government does not tax LLCs as businesses, some state governments do, and the LLC must pay taxes on any income the company earns.
Bibliography
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Hillman, Robert W. "Limited Liability in Historical Perspective." Washington and Lee Law Review 54.2 (1 Mar. 1997): 615–627. Print.
"The Key to Industrial Capitalism: Limited Liability." Economist. The Economist Newspaper Limited. 23 Dec. 1999. Web. 29 Feb. 2016. http://www.economist.com/node/347323
"Limited Liability Company." SBA. U.S. Small Business Administration. Web. 29 Feb. 2016. https://www.sba.gov/content/limited-liability-company-llc
Meyer, Stephen. "Limited Liability Company." Encyclopedia of Business and Finance. 3rd ed. Vol. 2. Farmington Hills, MI: Macmillan Reference USA, 2014. 487–488. Print.