Whether you plan to establish a limited company or a limited liability partnership (LLP), it is important to understand what is meant by “limited liability”. Most business owners will have heard of the term but may not fully understand how it provides protection from personal financial and legal risk. Limited liability effectively means that, as a business owner or shareholder, your personal exposure to financial risk is significantly reduced. In this article we will explain how limited liability works, the liability for each type of company and when limited liability may not apply.
What is limited liability?
Limited liability is a legal concept that limits the personal liability of a company’s owners (i.e. shareholders) to the amount of their investment in the business. This is because, in the eyes of the law, the assets of the business are separate and distinct from those of the owners. In practical terms, this means that the personal assets of shareholders cannot be used to satisfy the company’s debts, liabilities or legal obligations.
The concept of limited liability offers considerable legal and financial protection to company and LLP owners. Most importantly, limited liability offers personal financial protection in the event that the business ever encounters difficulties, i.e. financial difficulties, legal action or bankruptcy.
Limited liability applies from the moment that your limited company or limited liability partnership (LLP) is formally registered with Companies House. At this point the registered business becomes a separate legal entity from its shareholders.
By reducing personal risk, limited liability ultimately promotes entrepreneurship and encourages greater investment in businesses. It is important to note, however, that limited liability does not provide protection against personal liability. This may apply in the case of fraud or other illegal activities for which the owners can be held personally liable.
What are the four types of company?
The Companies Act 2006 (CA 2006) sets out four types of company:
- Companies limited by shares – may be private or public, although private companies limited by shares represent the vast majority of all companies in the UK
- Companies limited by guarantee
- Companies with unlimited liability
- Community interest companies (CIC) – may be a company limited by shares or by guarantee formed in accordance with part 2 of the Companies (Audit, Investigations and Community Enterprise) Act 2004.
“Limited by shares” is a type of company structure which means that the liability of shareholders to creditors is limited to the nominal value of the shares held. This is different from companies limited by guarantee, which have “guarantors” and a “guaranteed amount” (see below). Most limited companies are “limited by shares”.
A company limited by shares typically has the following key attributes:
- Legally separate from its owners
- Business and personal finances are separate
- Has shares and shareholders
- Can retain any profits made after tax
Shareholders in a company that is limited by shares are obliged to cover the company’s debts only up to the unpaid nominal value of their shareholding in the business. This is why the liability is “limited”. The nominal value is the minimum amount paid (or to be paid) for a share in the company. This is why it is extremely common to see the nominal value of shares set to just £1, which means that shareholders have negligible exposure to personal financial risk. If the shareholder has already paid the nominal value of the shares then she-or-he will have no more financial liability.
When a company is registered with Companies House, details of any shareholding must be provided in a “statement of capital”. The statement of capital outlines the share capital of the company (i.e. the number of shares, the class of each and their value) and the details of shareholders. In addition, certain “prescribed particulars” must be provided outlining the rights of each share class including:
- The share of dividends
- Whether the shares can be exchanged or redeemed for money, and
- Whether the shareholder has the right to vote on certain company matters, and if so, how many votes she-or-he has.
What is a company “limited by guarantee”?
Section 3(3) of the CA 2006 states that a company is limited by guarantee “if their liability is limited to such amount as the members undertake to contribute to the assets of the company in the event of its being wound up”. Unlike a company limited by shares, a company that is limited by guarantee has no shareholders. Instead, a company limited by guarantee has one or more guarantors who agree to pay a guaranteed amount if the company goes into liquidation or becomes insolvent.
The guaranteed amount is typically a nominal value of £1, £10, or £100. Again, this means that any personal liability in the event that the company cannot service its own debts is limited to a relatively small amount.
This type of company structure is typically adopted for “not-for-profit” entities such as charities, clubs or other entities that have a social or community-focused objective rather than making a profit.
Companies that are limited by guarantee typically have the following key attributes:
- Legally separate from its owners
- Business and personal finances are separate
- Has guarantors and a “‘”guaranteed amount”
- Invests profits back into the company
Guarantors are members who are listed on the formal register of members who control the company, make important decisions and take no profit. Any profits are instead retained or reinvested by the company.
In accordance with section 11 of the CA 2006, upon incorporation a “statement of guarantee” must be provided to Companies House. This states that if the company is wound up then the members will contribute up to a specified amount towards the assets of the company. The amount may be used towards any:
- Payment of the debt and liabilities of the company limited by guarantee
- Payment of costs, charges and expenses of winding up and
- Adjustment of the rights of the contributories among themselves.
What is a company with “unlimited liability”?
Members of an unlimited liability company have no protection from liability. Although members are not directly liable to the company’s creditors, if the company cannot cover its debts then creditors can petition for the company to be wound up. In this case members, both present and past (subject to certain limitations), may be liable for its debts and liabilities and for the expenses of the winding up.
When does limited liability not apply?
Members of limited liability companies may not be protected in all circumstances. This means that they will be held personally liable for any wrongdoing or liabilities. Although the following list of exceptions to limited liability is by no means exhaustive, such wrongdoings or liabilities may include:
- If a member personally guarantees a loan or debt of the company – in which case the member will be personally liable
- If a director breaches their statutory obligations – including failure to file Confirmation Statements and company accounts, to keep statutory company records or registers or to disclose conflicts of interest
- If health and safety law has been breached – board members have a collective and individual responsibility for health and safety and can be held personally liable if the law is breached
- Wrongful training – wrongful trading occurs when a company continues to operate even though members knew, or should have known, that there was no reasonable prospect of avoiding insolvent liquidation or insolvent administration. If it can be shown, however, that the member/s did everything possible to mitigate any potential loss to creditors then they may not be required to contribute to any assets.
- Fraudulent or unlawful activities – In the event that a member is found to have been involved in fraudulent or unlawful business activities then they will not benefit from limited liability and may be held personally liable.
How can I limit my personal liability if an exception applies?
In certain circumstances, as outlined above, a member of a limited liability company may still be held liable if one of the above exceptions applies. The financial risk of liability can be mitigated by taking out appropriate insurance policies – e.g. insurance against public liability, employers’ liability, professional indemnity and directors’ & officers’ Liability.
Most UK companies are established as private companies limited by shares. It is important to consider carefully and decide on the best business structure for your limited company or LLP. As we have outlined in this article, the four main types of structure have different implications when it comes to your personal liability. Limited personal liability comes with considerable advantages, but it also comes with a trade-off in terms of annual filing and disclosure. If you are unsure of the best structure for your needs then seek expert advice before you proceed. Doing so will ensure that you are protected from company liability in the future.
Uniwide specialises in all aspects of UK company formation. We offer a range of exclusive UK company formation packages, including Private Company Limited by Shares, Private Company Limited by Guarantee, Limited Liability Partnership and Non-Resident company registration, all backed up by our excellent customer service.