Definition and Examples of Unlimited Liability
Unlimited liability means liability that’ s not capped by law or a contract. A single owner or joint owner of a company has unlimited liability when they are fully liable for all of the company’s financial and non-financial liabilities. A company’s liabilities may include, for instance, damages assessed against the firm in lawsuits or other litigations.
The qualifier "unlimited" refers to the limits between the business entity and its owners. When business owners have unlimited liability, they can be fully responsible for their company’s debts and other financial obligations and must cover for them from their personal assets
An example of unlimited liability is a business created by an individual. For instance, suppose that an entrepreneur creates a construction business. They set up their business as an individual so they and their company are legally the same. If the company gets into financial trouble and is unable to pay its debts, creditors will use the entrepreneur’s personal assets to pay the company’s debts.
How Does Unlimited Liability Work?
The owners of a business have unlimited liability when there is no legal separation between the owners and the business entity. The owners are responsible for all liabilities and debts of the business. If the business lacks the funds to pay its debts or meet other liabilities, the owners must use their personal assets to satisfy those obligations.
Types of Unlimited Liability
Two types of business organizations have unlimited liability: sole proprietorships and general partnerships.
A sole proprietorship is when an individual has total control over a business. Because the individual and the business constitute one legal entity, the individual’s personal assets can be used to satisfy the business’s financial obligations.
A general partnership consists of two or more people who have agreed to go into business together. Unless the partnership agreement states otherwise, the partners share equally in the profits and losses of the business. Each partner has the authority to make decisions that create obligations for the others. For instance, if one partner signs a mortgage agreement on behalf of the partnership to purchase a commercial building, the other partners will share liability for the debt.
An option to a general partnership is a limited partnership, which includes both limited partners and general partners. Only the general partners have unlimited liability.
Pros and Cons of Unlimited Liability
Control over business
Easy to create
Simple payment structure
Business dissolves if the owner passes
- Control over business: Owners can make decisions quickly because they have total control over the business.
- Easy to create: Unlimited liability businesses require less paperwork and have fewer restrictions.
- Simple payment structure: Profits and losses are passed directly to the owners, who report them on their personal tax returns.
- No protection from liabilities: If the business suffers a large financial loss, the loss will be passed to the owners.
- Business dissolves if the owner passes: A partnership also dissolves when a partner dies unless the partnership agreement states otherwise.
Ways to Avoid Unlimited Liability
Prospective business owners can avoid the risks associated with unlimited liability by establishing their business as either a limited liability company (LLC) or a corporation. Both types of organizations shield owners from personal liability for the company’s debts and financial obligations.
Limited Liability Company
An LLC has elements of a partnership and a corporation. The company may be owned by one or more individuals, corporations, or other businesses, which are called members. State laws dictate how an LLC may be created. The company’s operating agreement determines how profits and losses are distributed to members.
LLC's aren't subject to taxation. Instead, members pay federal and state taxes on their share of financial distributions.
A corporation is a legal entity owned by shareholders and overseen by a board of directors. The board appoints corporate officers, who carry out the board’s policies and run the company’s day-to-day operations. Shareholders aren’t liable for the company’s debts and other financial obligations. Directors and officers aren’t liable as long as they haven’t breached their fiduciary duties to the shareholders.
- Unlimited liability means liability that’s not restricted by law or a contract.
- When business owners have unlimited liability, their personal assets can be used to pay the company’s debts.
- Sole proprietors and general partners have unlimited liability for their company’s financial obligations.
- Prospective business owners can shield themselves from liability by setting up their business as a limited liability company or corporation.