Unfounded Criticism of Limited Liability Companies

In today’s business and economic climate, limited liability companies are criticised as being of benefit solely to large-scale investors. But this criticism of limited liability companies is unfounded, as this is what they were intended to do from the outset. Discuss.

A limited liability partnership (LLP) is created by registration of an incorporation document with the Registrar of Companies and it is a flexible form of business enterprise that blends elements of partnership and corporate structures, as a legal form of business that provides limited liability to its owners. The memorandum of a limited company states that the liability of the members is limited and where the company is limited by guarantee this clause may contain the terms of the guarantee, though this may appear in the articles of association.

It is true that large scale investors have been benefited by limited liability as their financial liability is limited to a fixed sum which means if a company with limited liability is sued, then the plaintiffs are suing the company, not its owners or investors. They are not personally liable for any of the debts of the company depending on state shield laws, other than for the value of his investment in that company. By contrast, sole traders and partners in general partnerships are each liable for all the debts of the business which calls unlimited liability. The Limited Liability Partnerships Act 2000 created an LLP as a body with legal personality separate from its members (unlike a normal partnership) which is governed under a hybrid system of law partially from company law and partially from partnership law. Unlike normal partnerships the liability of members of LLP on winding up is limited to the amount of capital they contributed to the LLP. In the decades since case of Salomon v A Salomon & Co Ltd [1897] AC 22, various exceptional circumstances have been delineated, both by legislatures and the judiciary, in England and elsewhere (including Ireland) when courts can legitimately disregard a company’s separate legal personality, such as where crime or fraud has been committed. The effect of the Lords’ unanimous ruling was to firmly uphold the doctrine of corporate personality, as set out in the Companies Act 1862. The House noted:

“The company is at law a different person altogether from the subscribers to the Memorandum, and though it may be that after incorporation of the business is precisely the same as it was before and the same persons and managers, and the same hands receive the profits, the company is not in law the agent of the subscribers or trustees for them. Nor are the subscribers or members liable in any shape or form except to the extent and in the manner provided by the act.”

For taxation, An LLC can elect to be taxed as a sole proprietor, partnership, S corporation or C corporation (as long as they would otherwise qualify for such tax treatment), providing for a great deal of flexibility thus they could benefit from check-the-box taxation. Sole traders and partnerships with unlimited liability pay income tax. Using default tax classification, profits are taxed personally at the member level, not at the LLC level. Companies pay Corporation tax on their taxable profits. There is a wider range of allowances and tax-deductible costs that can be offset against a company’s profits. In addition, the current level of Corporation Tax is lower than income tax rates. Also, once the limited liability formed, a company has everlasting life. A company can remain dormant for as long as necessary, for example, its purpose it just to prevent the name being used by another company. The expenses associated with keeping a company on the register are a £15.00 fee for registering an annual return. And, while the company is dormant, various other documents and annual company balance sheets must still be prepared and filed at Companies House. Dormant company audit exemption may be claimed by a limited company that has not traded during a financial year, unless it is banking or insurance company or an authorised person under the Financial Services Act 1986. Directors, management and employees act as agent of the company. If they leave, retire, die – the company remains in existence. A company can only be terminated by winding up, liquidation or other order of the courts or Registrar of Companies which provide greater flexibility to investors while they take any decisions. The issue, transfer or sale of shares is a relatively straightforward process, although existing shareholders are protected via their “preemption” rights and by company legislation that seeks to protect the interests of minority investors. The process of lending to a company is also easier than with other business forms. The lending bank may be able to secure its loan against certain assets of the business (a “floating charge”) or against the business as a whole (“fixed charge”.

Although a shareholder’s liability for the company’s actions is limited, the shareholder may still be liable for its own acts. For example, the directors of small companies (who are frequently also shareholders) are often required to give personal guarantees of the company’s debts to those lending to the company. They will then be liable for those debts in the event that the company cannot pay, although the other shareholders will not be so liable. This is known as co-signing. Moreover, it may be more difficult to raise financial capital for an LLC as investors may be more comfortable investing funds in the better-understood corporate form with a view toward an eventual Initial Public Offering. One possible solution may be to form a new corporation and merge into it, dissolving the LLC and converting into a corporation. Minority discounts for estate planning purposes may be lower in a limited liability company than a corporation. Since LLCs are easier to dissolve, there is greater access to the business assets. Some experts believe that limited liability Company discounts may only be 15% compared to 25% to 40% for a closely-held corporation so investors would get lower dividends. Also, their earning would be deduced as earnings of most members of an LLC are generally subject to self-employment tax. By contrast, earnings of an S corporation, after paying a reasonable salary to the shareholders working in the business, can be passed through as distributions of profits and are not subject to self-employment taxes. The main advantages of a sole proprietorship are that they are easy to start up, they are subject to fewer regulations relative to other types of businesses, the owner has full autonomy with regard to business decisions, and they are easy to discontinue. As a sole proprietor usually has a quick decision process and doesn’t have any opposition when making a decision as he or she has total control of his or her business. All profits and losses accrue to the owner. The owner does not have the tension regarding conflicts among the partners as there are no partners. It would solve the problems of conflicts between managers and shareholders. The principals of LLCs use many different titles—e.g., member, manager, managing member, managing director, chief executive officer, president, and partner. As such, it can be difficult to determine who actually has the authority to enter into a contract on the LLC’s behalf. Although there are advantages for taxation for limited liability Company, A sole proprietorship is not a corporation; it does not pay corporate taxes, but rather the person who organized the business pays self employment taxes on the profits made, making tax filing much simpler. A sole proprietorship also does not have to be concerned with double taxation, as a corporate entity would. An unlimited company has the advantage of being a legal entity separate from its members, but lacks the advantage that most people seek from incorporation, that is the limited liability of the members.

Moreover, there is a different size of investors in Limited Liability Company. Section 7 of the Companies Act 2006 permits the formation of single member limited liabilities companies. It is now no longer necessary to have an “artificial” member, who exists in many private companies which in fact have a sole proprietor but where, for example, a spouse hold a nominee share to fulfil the previous two-member requirement. The same is true of subsidiaries whether trading or dormant where someone such as the group secretary or a separate nominee company has in the past had to hold a share or shares in the subsidiary, normally under a declaration of trust and a blank transfer form in favour of the parent company so that the shareholding can be recalled from the nominee at any time. This means limited liability companies are not benefit solely to large-scale investors, companies with small number of investors could be benefit as well.

In conclusion, comparing with the advantages of unlimited liability, the investors of Limited Liability Company would definitely benefit from limited liability. However, the benefit they gain would only depend on the size and the nature of company, also to the extent of the proportion of shares they own. A disadvantage of a sole proprietorship is that as a business becomes successful, the risks accompanying the business tend to grow and it is a key role for a company to minimize those risks and maintain the company, therefore it would be a grand reason for investors to invest in Limited Liability Company.