Till today there has been a lot of debate on the topic of limited liability for corporations and their shareholders and owners. Most corporate secretarial service providers will cite the advantage of limited liability as a reason for new startups to choose this corporate form. But is limited liability a myth or a fact in the real world? Do the corporate secretarial service providers tell the whole truth as far as limited liability is concerned? This article aims to help readers clear their doubts and put their worry to rest.
Many shareholders of corporation still hold the assumptions that their liability is limited to the amount of shares they hold in a corporation and not a dollar more. This is only half-truth. Here comes the other half.
Supposing, someone has a valid claim against a business that exceeds its assets. If the business is a sole-proprietorship, the claimant can take the owner’s personal property after taking the assets of the business. On the other hand, if the business is a corporation, only the assets of the business can be used to pay off the claimant, not the personal property of the shareholders of the business.
This concept is only true in the context of owning shares as an investor in the company and the investor does NOT work in the business whatsoever. It doesn’t apply if the shareholder is the owner and at the same time running the business. Let’s explore why.
Companies generally create liabilities that far exceed their assets value in 2 ways: by borrowing money they can’t repay, and losing a legal lawsuit.
The first situation is very common and it usually occurs when a business takes out a loan from a bank in the expectation of good business in the near future. The ideal plan is to pay off the loan with the profits from the anticipated business. However, trouble arises when the anticipated business does not pan out as planned and the business is no longer able to repay the loan. When the situation is bad enough, the company goes bankrupt with all unpaid loans that exceed the value of its assets.
Theoretically, incorporation protects the owners from having their personal assets seized to repay those unpaid loans. In practice, however, lenders circumvent this limited liability feature of incorporation by demanding personal guarantees from the owners of the business before making loans to them.
Personal guarantees are just side agreements signed along with the loan agreements that make owners personally responsible for repayment of loans should their businesses fail to meet the financial obligations of those loans. This personal guarantee device truly destroys the value of limited liability.
In the second situation when the company lost a legal lawsuit. For example, an employee of your car repair shop fixes a customer’s brake negligently and thereby causes an accident. In such a case, the injured party can sue your company and the negligent employee for damages and thus bypassing the limited liability of the corporate form.
Therefore, the concept of limited liability in corporate form is mainly a MYTH for owners and shareholders who work in the business. However, it is real only for shareholders as investors who do not participate in the business at all.
This article is original and is the work of Victor Ang CEO Crossbow Consulting Group. He can be reached at firstname.lastname@example.org for more information.