What Does Unlimited Liability Mean for Businesses?

What is unlimited liability in business?

The term “unlimited liability” means that business owners are personally responsible for all company debts and financial obligations.

In an unlimited liability business structure, the business owner might have complete control over the business and be fully entitled to its profits after taxes. However, it also means that they are personally responsible for any business debts. If the business owes a debt that it can’t pay back, creditors can legally seize the business owner’s personal assets to satisfy the debt.

Business structures with unlimited liability

One type of business structure with unlimited liability is a sole proprietorship. This is where the business owner (also known as a sole proprietor or sole trader) has complete control over their business and is fully entitled to its profits, but is also responsible for all its losses and debts. In a sole proprietorship, there is no legal distinction between the business owner and the business.

Another type of unlimited liability company is a general partnership. This is where two or more individuals agree to share ownership of the business, including profits, assets, debts, and losses. Like a sole proprietor, each partner is equally liable for business debts and financial obligations.

An advantage of these types of business structures is that they are unincorporated, which means business owners don’t need to register their business with the state to legally operate. Thus, they have more freedom since they're subject to fewer compliance regulations and disclosure requirements.

Real-world examples of unlimited liability business types

• Freelancer. Freelancers, such as freelance writers and graphic designers, operate as independent contractors. They often get paid per project and handle their own health insurance and taxes. Operating as a sole proprietor would make sense for them since there are few startup costs involved and they can report income on their personal tax return. 
• IT consultant. IT consultants offer troubleshooting services and expertise on technical issues that businesses often face. Since consultants often work on a contract basis, usually to solve a specific problem, they are likely to work as sole proprietors.
• Personal trainer. Personal trainers or fitness coaches work directly with clients at gyms or from any location. Their job involves creating tailored fitness and nutrition programs for clients, and often requires certification. Since they often work solo, they can easily operate as a sole proprietor. But as their client base grows, they may want to consider mitigating the risks of liability by restructuring as a limited liability company (LLC).
• Caterer. Caterers provide large amounts of food for events. There can be a lot of labor involved, and caterers might operate as a general partnership if going into business with someone else. But as a catering business grows, or if they wish to hire employees, it may be best for each owner to limit their personal liability by forming a limited partnership (LP) or limited liability partnership (LLP).

Comparing limited and unlimited liability

Unlike with unlimited liability, businesses with limited liability—LLCs and LLPs—are legally considered a separate entity from the business owners. To gain limited liability status, the business must register with the state. When someone has limited liability, their personal wealth and assets receive a certain level of protection from their company’s risks and debts.

You may also mix these liability levels with a limited partnership (LP), in which at least one partner (often an investor) has limited liability but no involvement in the management of the business, and at least one general partner has unlimited liability plus the ability to manage business operations.

There are a few key differences between unlimited and limited liability for your business:

Business formation

• Unlimited liability: A company with unlimited liability is far easier to set up. There’s less paperwork involved and you don’t need to register it with the state. It’s as simple as taking on your first client or starting to do your work. You can, however, register a trade name or DBA (doing business as) to operate your business under.
• Limited liability: To set up an LLC, LLP, or LP, you’ll need to follow state procedures. This includes filing articles of organization, selecting a registered agent, and creating an operating agreement. Going through this process sets up your business as a separate entity from the owner or owners, which is what offers some protection from liability.

Control over business decisions

• Unlimited liability: If you are a sole proprietor, you have full control over business decisions. Similarly, a general partnership distributes decision authority equally unless otherwise agreed to in a partnership agreement. In a limited partnership, the general partner retains full control over business decisions, while the limited partner has no authority over business decisions.
• Limited liability: If you’re the sole member of an LLC, you have full control over business decisions. If you are in an LLP, decision authority is generally assumed to be distributed equally unless otherwise stated in your partnership agreement. In a multi-member LLC, responsibility for business decisions should be stated in your operating agreement form. In the absence of an agreement, all members of a member-managed LLC typically share decision-making authority; in a manager-managed LLC, managers control business decisions while members remain neutral or passive.

Risk exposure

• Unlimited liability: With unlimited liability, you’re exposed to a significant amount of personal risk. You could be forced to use your personal assets—such as your savings, investments, and property—to cover any losses. These losses can occur when a company debt is unpaid or, in some cases, when a lawsuit is filed against the business.
• Limited liability: The amount of personal risk you’re exposed to is limited, mainly in that your personal assets can’t be seized to cover business debts or losses—if your business fails to turn a profit, you risk losing only your initial investment. Limited liability can be pierced in the event of fraud or other illegal activity. 

Impacts to credit and investment

• Unlimited liability: Because of the amount of risk you’re exposed to, it may be more difficult to secure funding for your business. Creditors may not be comfortable granting you a line of credit if you’re more likely to default on a loan—you might not have enough personal assets to repay a debt. Similarly, investors might feel uncomfortable since there’s a higher risk of losing their investment.
• Limited liability: Since limited liability companies are legally separate from their owners, you can establish a business line of credit separate from you as an individual. This is especially important as your business grows—you can establish good business relationships with lenders and access funding more easily.

How to mitigate the risks of unlimited liability

If you’re starting a business and don’t feel comfortable taking on unlimited personal risk, you can protect yourself with a formal limited liability business structure. While this requires an upfront cost, it could pay off if you become subject to legal action. The sooner you take these steps, the sooner you reduce your exposure to risk.

Create an LLC

An LLC is the most popular type of limited liability arrangement. This structure legally separates you from your business, which offers a layer of protection for your personal assets. LLCs still offer a lot of flexibility in terms of ownership terms and management structure. 

You can convert to an LLC even if you’re already operating your business. To form an LLC, you will need to register your business with the state, which requires selecting a unique name and filing paperwork with your Secretary of State. You can file this paperwork yourself, or work with an LLC formation service like LegalZoom to ensure the details are all in order.

Secure liability insurance

You can purchase business liability insurance to protect against business setbacks.

A general liability insurance policy is a good place to start. This provides coverage against lawsuits so your personal assets aren’t at risk if your business gets sued.

There are many additional types of liability insurance you can purchase, depending on what situations your business is most likely to encounter, like damage to property, professional mistakes, or cybersecurity breaches. 

Establish good business practices

Especially if you choose to operate as a sole proprietor, it’s important to maintain good business practices when operating. Make sure you keep clear financial records, track business expenses, and separate your professional operations from your personal finances and accounts wherever possible. To open a business bank account, you will need to formally become an LLC or LLP and file for a federal employer identification number (EIN).

FAQs

What are the benefits of unlimited liability?

Unlimited liability companies, such as sole proprietorships and general partnerships, are more flexible and easier to set up. There are fewer costs involved in starting, and owners have greater control over business decisions.

Also, unlimited liability companies are subject to less government oversight and regulation. Business owners aren’t required to register with the state (though they can set up a DBA or trade name) and they don’t have to publicly disclose their finances.

What are the disadvantages of unlimited liability?

An unlimited liability company isn’t considered a separate entity from the owner(s), so they are personally liable for all its financial obligations. This means that if the company incurs a debt that it can’t repay, or if someone files a lawsuit against the company, it’s no different than suing the owner as a person—the owner’s personal assets are at risk for seizure or liquidation to pay off those costs.

Can a sole proprietor or general partner convert to a limited liability structure?

Yes, you can change your business structure at any time. This is generally the same process as forming a brand-new LLC, though if you’re already operating and are using a registered trade name or DBA, you will need to fill out additional paperwork to transfer it to your new business. 

How is unlimited liability taxed?

Unlimited liability companies are taxed depending on the type of business entity. Sole proprietorships are subject to pass-through taxation, which means that the business owner would report all profits and losses on their personal tax return. Similarly, general partnerships are also pass-through entities, and each partner reports their share of business income on their personal return.