ABA Family Legal Guide

Forming and Operating a Small Business

Types of Business Organizations

Corporations

How do corporations limit the liability of their owners?

Sole proprietors and many kinds of partners potentially face unlimited liability. Shareholders of a corporation, on the other hand, generally are at risk only for the amount of money or other property they invest in the corporation, though some state laws make shareholders of small corporations liable for unpaid wages. So if you put up $5,000 in return for stock in the company, you may lose $5,000, but creditors of the corporation can't come after you personally for more payment. Even if the business is deader than a three-day-old halibut, shareholders can lose only their investment.

This ability to shield personal assets from the creditors of a corporation is attractive to investors. Given a choice, an investor always will choose limited liability over unlimited liability.

When shareholders of a corporation guarantee its debts, co-sign its notes in their individual capacity, or pledge their own assets as security for loans to the corporation, which frequently occurs because of creditors' demands, the shareholders waive their limited liability with respect to those debts, notes, or assets. But this is a limited waiver. The shareholders in question still have limited liability with respect to other debts or obligations of the corporation.

The following example will help to illustrate this distinction. Suppose Bill is the sole shareholder in Bill's Bakeries, Inc. He personally guarantees payment of a $20,000 bank loan that is used to purchase a new delivery truck for the corporation. Alas, people don't want Bill's buns, and the corporation ceases doing business and is liquidated. At the time of liquidation, the corporation has $50,000 in assets, and the creditors of the corporation other than the bank that made the truck loan have valid claims of $75,000. The bank can recover whatever is still owed on the truck loan directly from Bill because of the personal guaranty. The other creditors, however, can recover only $50,000 from the corporation. They cannot recover the additional $25,000 they are owed from either the corporation, because it does not have any more assets, or from the shareholder, because the shareholder's other assets are protected by the limited liability doctrine.

There are some exceptions to limited liability. For example in cases of fraud or wrong-doing, a shareholder or director of a corporation may be personally liable.