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What Does Limitation of Liability Really Mean?

what is limitation of liability and what it means for business with no more money

I recently wrote about the concept of limitation of liability for LLCs and corporations. In those articles, I defined the concept in a general way.

For those of you who are very new to business ownership, let me explain the concept in a more concrete way. It always helps when you have a better gut feel for how an important business concept works.

After the Business is Set Up, You Have to Fund the Business

In my articles about the LLC and the corporation, I wrote about opening a bank account under the name of the LLC or corporation. This is a part of the setting-up process for LLCs and corporations.

After you open the account, you’ll have to put money into that account. That money should be the money you saved to start your business and whatever you received from the folks who invested in your business.

As you build your business, you’ll pay expenses from this bank account and deposit your business receipts into this account. If you borrowed money to start your business, you’ll repay the loan from this account.

If you need more money and can borrow the money in the LLC or corporation’s name, then the loan goes into this account. Later, you also repay the loan from this account.

Your Business Might Owe More Than It Owns

Things sometimes don’t go well. Maybe you can’t repay your loan. Maybe you bought inventory on credit, and the widgets didn’t sell, but the payment to your supplier is due or overdue. Maybe you lost a lawsuit and now have to pay damages.

Basically, you owe more than what you have in that bank account and can’t repay the debt by the due date.

If Your Business Declares Bankruptcy, It Pays the Debt from Its Existing Assets

With an LLC or a corporation, you have the option of declaring bankruptcy of the business. Your creditors—the people to whom you owe money—get to divide whatever’s left in your bank account. The creditors can also force you to sell all your other business assets and repay them from that.

But, if that’s not enough to repay your debts, then too bad for your creditors. They don’t get any more money. They don’t get to force you to pay from your personal savings.

This, in an overly simplified way, is what limitation of liability means.

Some Real-Life Complications

In real life, things are of course more complicated. For one, and especially in the first few years of your business, you’ll probably have to personally co-sign a loan. So, some lenders will be able to get to your personal assets even if your business declares bankruptcy.

For another, depending on which country you’re located, there might be several flavors of bankruptcy laws. Things work differently depending on which flavor you use. There’s also a pecking order for the creditors on who you have to pay back first.

And, of course, most businesses own more than one bank account, so the accounting will be more complicated. But, hopefully, now you have a better gut-level feel for the concept of limitation of liability.

A Last Reminder: Limitation of Liability and Keeping Up the Corporate Formalities

As you can see, the concept of limitation of liability is a very good thing for LLCs and corporations. The easiest way to lose this protection is if you don’t keep up with business formalities. So don’t forget to hold your annual meetings and keep the meeting minutes and don’t co-mingle your personal and business finances.

Otherwise, you’ll lose your liability limitation. A creditor can pierce your corporate veil and get to your personal assets.

So this article is a bit of a detour. Next, we go back to our scheduled programming on what to do to start a business. Let’s see how we can find a good name for your business.

DISCLAIMER: This article does not constitute legal or accounting advice. Instead, it contains general information. The information gives you the background you’ll need to hit the ground running when you do go get advice from a lawyer or accountant. Only lawyers and accountants properly licensed in your state/country are qualified to give you legal or accounting advice.

Questions? Comments?