Unlimited liability is the legal obligation of company founders and business owners to repay, in full, the debt and other financial obligations of their companies. The legal obligation generally exists in businesses that are sole proprietorships or general partnerships. Under the two business structures, each company owner is equally responsible for repaying the business’ financial obligations.
Unlimited Liability vs. Limited Liability
With limited liability, a business owner is not legally obligated to repay the financial obligations of his company. It is a key reason that most businesses structure themselves as limited liability corporations or limited partnerships. The structures offer limited liability for business owners.
Limited liability companies and limited partnerships offer some liability protection to owners. Under these two structures, lenders cannot seize the personal assets of owners to settle outstanding claims against the company. Due to the legal protection, the loss of the business owners is limited to the capital they invested in the business.
The key differences between limited and unlimited liability can be seen below:
Business owners are legally obligated to repay the debt obligations of their companies
Business owners are not legally obligated to repay the debt obligations of their companies
The owners' personal assets can be seized to settle the financial obligations of the business
The owners' personal assets cannot be seized to settle the financial obligations of the business
Exists in sole proprietorships and general partnerships
Exists in limited liability companies and partnerships
Example of Unlimited Liability
Let us assume two partners manage a business in which they invested $20,000 each. The business also previously took out a loan of $100,000 that needs to be repaid. If the business is unable to pay back the loan, the two partners will be equally liable to settle the obligation.
In such an event, the personal assets of the partners can be seized against the claims. If one partner does not own any assets, the second partner’s assets will be seized to recover the full $100,000.
If the business were structured as a limited liability corporation or limited partnership, the two partners would only lose their initial investment of $20,000 each. This example illustrates the benefit of adopting limited liability structures. With limited liability, the personal wealth of the business owners is not at risk. Only their initial capital is lost.
Implications of Unlimited Liability
With unlimited liability, the liability of business owners is not capped. The structure can be detrimental to the personal wealth of business owners. Unlimited liability does not provide liability protection to business owners, as personal assets of owners can be seized to settle the financial obligations of the company.
The reason business owners of sole proprietorships and partnerships are subject to unlimited liability is because both business structures do not create a separate legal entity. The owners and the business are one entity. A limited partnership agreement offers limited liability to owners, as it separates the owners from the business by creating a separate legal entity. The business is, in itself, a legal entity and responsible for paying its obligations.
Due to this fact, only small businesses with little or no financial obligations are sole proprietorships and partnerships. While sole proprietorships and general partnerships are easier to set up and offer greater control, they can be dangerous for the owners of mid-sized and large businesses. As a result, businesses that start as sole proprietorships and general partnerships tend to adopt limited liability structures as they grow in size.
Unlimited liability is not limited to contractual financial obligations and includes other obligations that may arise against the business. Contingent liabilities arising from consumer lawsuits or legal action against the business can be detrimental for business owners of sole proprietorships and partnerships. Lawsuits potentially create huge liabilities. It explains why even smaller companies tend to structure as limited liability corporations.
Unlimited Liability and Capital Limits
General partnerships can also be structured in a way that allows business owners to be liable only to the extent of their ownership in the business. Under such an agreement, each partner is liable for a pro-rated share (based on their equity stake in the business) of the total liability amount. The structure can be best described as a hybrid between limited and unlimited liability.
Let us assume that three equal partners manage a business in which they invested $20,000 each. The business also owes $120,000 that it is unable to settle. Since each partner owns 33% of the company, each partner can be held liable for a maximum amount of $40,000.
Even if one partner is unable to cover his share of the liabilities, lenders can only get a maximum of $40,000 each from the other two partners. The hybrid structure provides some protection to owners but is not commonly used.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep learning and advancing your career, the additional CFI resources below will be useful:
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