The Concept of Limited Liability
Limited liability is a legal status that protects business shareholders from personal financial responsibility for a business' losses in lawsuits or bankruptcies. Basically, shareholders' losses are limited to the amount of money they originally invested in the company at the time they purchased the stock. It is meant to encourage investment by protecting shareholders from the inherent risks associated with being in business. Critics, however, say it encourages companies to take irresponsible risks because it shields them from the potential damages.
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Early History
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According to Charlie Cray at the Center for Corporate Policy, the concept of limited liability dates as far back as 2000 B.C., when merchants used it to raise the considerable amount of investor capital needed to pay for seagoing vessels. Limited liability protection granted to English companies in the 15th century was a key factor in separating the corporate entity from the individual and the state. In England, limited liability protection was originally bestowed mainly to large companies that concentrated on foreign trading to help them raise the vast amounts of capital from private investors necessary for such enterprises. But limited liability companies were considered to have an inherent recklessness, and the British Parliament required them to use the designation "LLC" in their company names to distinguish them from non-limited-liability entities, which were considered more responsible, until 1855.
Limited Liability in the U.S.
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Limited liability was granted to American companies as far back as the 18th century, but it did not become widespread until the 1800s. Its introduction was greeted with debate from critics who said it promoted "dishonesty and fraud by limiting creditors' rights of redress," and others who said it benefited only wealthy entrepreneurs and did little for yeoman farmers, according to Cray. But it eventually became the rule in American business, and is credited as one of the major factors influencing the rise of American industry.
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The Origin of Limited Liability Corporations (LLCs)
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The concept of the limited liability corporation is usually considered to have originated with a German law passed in 1892 called the Giesellschaft mit beschrankter Haftung (GmbH). Other countries had enacted similar legislation, but the German version was the one that became the model for the modern version of limited liability offered in Europe, Latin America and the United States. Laws defining LLCs in Europe and Latin America have common characteristics, including granting limited liability to the corporation, requiring the use of the word "limited" in the company name, providing that the LLC can sue or be sued, permitting a member of an association to control admission of new members to the entity, and the dissolution of the death of a member unless it is specifically stated otherwise in the corporation's organizational documents.
LLCs in the United States
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In the United States, the LLC designation is granted by individual state statutes and recognized by the Internal Revenue Service (IRS) for tax purposes. But the LLC in the U.S. is a relatively new concept. The first LLC act was passed in 1977 in Wyoming, and states did not widely adopt similar statutes until the early 1990s. According to a 1993 Wall Street Journal article, the growing popularity of LLC designations in the U.S. was due in part to the 1988 IRS ruling, which says each owner's profits from an LLC are taxed only on his personal returns, like a partnership, not double-taxed, as with corporations. The ruling gives LLCs the tax advantages of a partnership and the limited liability protection of a corporation.
Contemporary Debates of Limited Liability
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The widespread adoption of LLC status by business entities that would have previously been considered partnerships--a designation that does not carry with it limited liability protection--has contributed to a contemporary debate over whether limited liability promotes irresponsible behavior by business entities. Critics say limited liability creates what economists call "moral hazard;" essentially, it increases the risks of bad behavior because it shifts the costs of such behavior to someone else--either to individuals harmed by a company's negligence or taxpayers who eventually pay for tax-deductible damages from corporate settlements. Critics have argued that limited liability protection should not be available to smaller corporations or when people who could potentially be harmed by a corporation's wrongdoing are not in a position to bargain with the corporation, according to Cray. Other suggested reforms include allowing limited-liability protection to shareholders but not company directors.
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References
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