Limited liability for small businesses
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Persons who wish to engage in business activities should do so via a form of business structure. The four main business structures are sole proprietorship, ordinary partnership, limited liability partnership and registered companies. The latter two are formed through a process called incorporation and are known as bodies corporate.
Under the Companies Act 2006, bodies corporate can be publicly or privately limited by shares. A company limited by shares is advantageous for shareholders as they gain limited liability, meaning that their liability is limited to the value of their shares. Thus, if a shareholder has a share of £1, they will be personally liable only to that value.
Accordingly, while a shareholder would lose their investment in the event of a company becoming insolvent, their personal wealth would remain ringfenced and safeguarded from the company’s issues. This is referred to as protection from the ‘veil of incorporation’ and applies just as much to one-man companies as it does to large corporations. Moreover, the courts are reluctant to pierce the veil, even in the unfortunate case of a company becoming insolvent with outstanding monies owed to creditors. A creditor cannot sue a shareholder for monies owed as their liability is to the company as a separate entity and not directly to the creditors. This contrasts with the position of a sole trader or partnership, which are held personally liable for business debts. Thus, limited liability is often seen as a benefit for bodies corporate, even in the case of small companies with little capital but big personal risks.
Limited liability negatives
Limited liability may appear attractive to those trying to allocate risk away from their personal assets; however, persons tempted by incorporation benefits should also be fully aware of the potential advantages and disadvantages in order to avoid potentially calamitous results. Small private companies should consider the following:
- Personal guarantees – as there are no minimum capital requirements and perhaps inadequate initial capital, small private companies may face barriers to borrowing against the security of their assets without a guarantee. It will be difficult for companies to obtain credit from banks as they commonly require some form of security over loans, such as personal guarantees. Loans are likely to be secured over personal assets such as the family home, but there is the risk that this asset could be sold to recover the loan.
- Administration – the privileges of limited liability are balanced with the need to comply with strict formalities (eg, directors’ duties), increased administrative burdens through document filing and the loss of privacy due to disclosure policies.
- Finances – although a company can be controlled by one person they cannot treat company assets as mere extensions of their private assets. Such action could lead said person to being held liable for theft, as the company is a separate legal person and the controlling party would be depriving the company of its assets.
- Tax – it may be appealing to have a modest income plus dividends from the company, thus keeping it in a lower tax band for tax and national insurance purposes. However, entrepreneurs may not realise that they are also burdened with corporation tax at 19% and dividend tax of between 7.5% and 38.1%.
- Liability – although uncommon, directors can be found personally liable for torts committed within a company, such as negligent misstatements in the context of company activity (eg, Elon Musk’s recent tweets). Another example is where a director continues to trade with the knowledge that a company will or has become insolvent. In such a case, the company’s separate legal personality can be set aside to hold the director personally liable.
For some small companies, the disadvantage of incorporation could outweigh the apparent benefits of limited liability. Parties looking to form a company should first consider seeking legal and financial advice to decide whether incorporation is the correct route to take for their business.