Learning Outcomes
After reading this article, you will be able to explain what is meant by legal personality and limited liability in a business context. You will be able to distinguish between incorporated and unincorporated business entities, describe the practical and legal consequences for business owners, and apply the relevant doctrines to problem scenarios. Understanding these topics will enable you to answer SQE2-style questions on business structures, registration requirements, liability, and parties to claims or contracts.
SQE2 Syllabus
For SQE2, you are required to understand the law and practice relating to legal personality and limited liability. In your revision, focus on:
- How different business forms acquire legal personality (or not) and its legal effects.
- The significance of separate entity status for contracts, ownership, and parties to proceedings.
- The principles and consequences of limited liability and unlimited liability.
- When exceptions to limited liability may arise, including piercing the corporate veil and insolvency-related personal liability.
- Identifying parties entitled to sue or be sued, as required when drafting and analysing business transactions and claims.
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
-
Which of the following business forms has a separate legal personality immediately upon formation?
- Partnership
- Limited liability partnership
- Sole trader
- Ordinary partnership
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Which statement accurately reflects limited liability?
- It only protects business assets, not personal assets.
- It always prevents a court from finding liability to creditors.
- It limits a member's liability to capital unpaid or a guaranteed amount.
- It guarantees creditors will recover debts in full.
-
If a company fails to pay a contract debt, who should a creditor normally pursue?
- The directors only
- The company as legal person
- The individual shareholders
- Whoever has day-to-day management control
-
True or false? In a general partnership, partners are not personally liable for partnership debts.
Introduction
Understanding legal personality and limited liability is essential for advising clients about the risks and protections of different business forms. These foundational concepts are frequently examined in contractual and contentious business scenarios on SQE2. This section outlines their application and significance in English law.
Incorporated and Unincorporated Businesses
Business organisations can be divided into incorporated entities (such as companies and limited liability partnerships) and unincorporated businesses (such as sole traders and general partnerships). The distinction has major consequences for ownership, liability, and legal proceedings.
Key Term: incorporated business
An entity with its own legal personality, distinct from those who own or manage it. It can own property, enter contracts, and sue or be sued in its own name.Key Term: unincorporated business
A business that does not have legal personality distinct from its owners. There is no legal separation between the business’s liabilities and those of its proprietors.
Separate Legal Personality
When a business has legal personality, it is treated by law as a “person” for most business purposes. This enables it to own assets, be party to contracts, and be the correct party to legal proceedings—regardless of who its owners are.
Key Term: separate legal personality
The business is a distinct “person” in law, separate from its owners, directors, and managers.
A company or LLP is an obvious example. Upon registration, the entity “comes into existence” as a legal person.
Worked Example 1.1
Rosa is the sole shareholder and director of R Farm Ltd, which leases land and sells produce. A wholesaler, Rivers Ltd, contracts with R Farm Ltd but is unpaid. Who may Rivers Ltd sue to recover the debt?
Answer:
Rivers Ltd should sue R Farm Ltd, which is the separate legal person and party to the contract. Rosa is not personally liable simply because she owns or manages the company.
Legal Personality: Implications for Contracts and Claims
An incorporated business enters into contracts in its own name. If sued, it is the named party in litigation. Assets, debts, and obligations belong to it, not to the individuals behind it.
By contrast, in unincorporated businesses (sole traders, general partnerships), contracts and obligations fall personally on the proprietors.
Key Term: sole trader
A single person who owns and runs their business. There is no distinction in law between the business and the person.Key Term: partnership
A relationship in which two or more persons carry on business in common with a view to profit, as defined in the Partnership Act 1890. The partnership is not a legal entity separate from the partners.
Liability for Debts: Unlimited and Limited
The type of business organisation determines whose assets are at risk if the business cannot pay its debts.
Key Term: unlimited liability
Owners are personally liable for all business debts and obligations. Their personal assets can be seized to satisfy creditors.
In sole trader and traditional partnerships, business obligations are the personal liabilities of the proprietor(s).
Conversely, limited liability means that losses are generally confined to what has been invested or agreed as a guarantee.
Key Term: limited liability
The liability of a shareholder or member is restricted to a specified amount—usually unpaid capital on shares or a stated guarantee.
In an LLP or limited company, creditors cannot (in general) reach the personal assets of members or shareholders to cover the entity’s contracts or debts.
Worked Example 1.2
Derek and Anita run a general partnership operating a club. The partnership borrows £40,000 from the bank. The business collapses with no assets and the loan is unpaid. Who can the bank sue for repayment?
Answer:
The bank can sue Derek and Anita personally. The partners are jointly and severally liable: each may be required to pay the full debt, with a right to recover a share from the other.
Limited Liability in Companies and LLPs
A company limited by shares or guarantee, or an LLP, is primarily liable for its debts and contracts. Members' or shareholders' liability is limited to:
- Any unpaid amount on shares (for a company limited by shares).
- The amount promised in a guarantee (for a company limited by guarantee).
- Any agreed capital under the LLP agreement (in the case of an LLP).
If the shares are fully paid or the guarantee met, the member or shareholder will not usually owe creditors anything further if the business fails.
Key Term: company limited by shares
A company where shareholder liability is limited to amounts unpaid on shares subscribed.Key Term: limited liability partnership (LLP)
A business, registered under the Limited Liability Partnerships Act 2000, with separate legal personality. Members’ liability is limited, but management structure resembles a partnership.Key Term: company limited by guarantee
Usually a non-profit entity where liability is limited to whatever members agree to contribute (eg £1) in the event of the company's winding up.
Protection by the Veil of Incorporation
Legal personality creates a “veil of incorporation,” which means the entity is distinct from those behind it. Usually, courts will not disregard this principle.
Key Term: veil of incorporation
The legal separation between the incorporated business entity and those who own or manage it.
Worked Example 1.3
Priya is the sole shareholder of a dormant limited company. The company owes £1,000 to a supplier. Can the supplier recover the debt from Priya personally if the company cannot pay?
Answer:
No, the supplier’s claim is against the company. If Priya’s shares are fully paid, she is protected by limited liability—the “veil” will not be lifted except in exceptional cases.
Exceptions and Personal Liability
There are narrow exceptions where courts or legislation allow a creditor to pursue those behind an incorporated entity:
- Where directors commit fraudulent or wrongful trading (Insolvency Act 1986).
- Where there is fraud or the company is a “sham”/facade for wrongdoing, in rare equitable cases.
- Where personal guarantees have been given for contracts or borrowing.
Exam Warning
Do not assume that limited liability is absolute. If a director acts fraudulently or is required by statute (as in wrongful trading), they may be liable beyond any shareholding or guarantee.
Registration and Publicity Requirements
Most incorporated businesses must be registered at Companies House. This registration creates the entity’s legal personality and triggers compliance with requirements on filing, accounts, registers, and public disclosure.
Unincorporated businesses have no such requirements.
Key Term: Companies House
The official registry for incorporated companies and LLPs in England and Wales. Filing with Companies House is required for a company or LLP to come into existence.
Comparisons: Effects on Ownership, Management, and Legal Proceedings
The distinction between incorporated and unincorporated forms has practical implications:
| Feature | Incorporated (Company/LLP) | Unincorporated (Sole Trader/Partnership) |
|---|---|---|
| Legal personality | Yes | No |
| Limited liability | Yes | No |
| Ownership of assets | Entity owns property | Proprietor(s) own property |
| Contracting parties | Entity contracts in own name | Proprietor(s) contract personally |
| Legal proceedings | Entity sues/is sued in own name | Proprietor(s) sue/are sued personally |
| Registration | Yes (Companies House) | No (other than any required HMRC or business reg) |
Worked Example 1.4
Lionel, Simon, and Chloe establish an LLP for their design firm. The LLP is sued for breach of a client contract. Chloe personally has no involvement in the contract. Who is the correct defendant in the claim?
Answer:
The LLP. As an incorporated entity with legal personality, only the LLP is sued. Chloe is not personally liable for the LLP’s breach.
When Limited Liability Does Not Apply
Limited liability can be overridden in specific circumstances:
- A member or director provides a personal or directors’ guarantee for a debt.
- The business trades fraudulently or wrongfully when insolvent.
- The incorporated entity is structured for the purpose of deceit or evasion.
Key Term: personal guarantee
An agreement by which an individual assumes personal liability for a specified debt should the business default.
Practical Implications for Exam Scenarios
SQE2 questions may require you to identify the correct party for claims and contracts, explain the implications for liability, draft a party clause, or apply the principles where mixed forms might be used (eg, a general partnership alongside a company).
Worked Example 1.5
ABC & Co trades as a partnership but registers a dormant company at Companies House for a future project. The partnership contract is signed by ABC & Co (the partnership, not the company). A supplier sues for invoice payment. Who are the parties?
Answer:
The correct parties are those trading as the partnership, as the company has not contracted or traded. The supplier must pursue the partners personally.
Revision Tip
In exam scenarios, check:
- Has the business form been created or registered (and when)?
- Who is a party to the contract or litigation—entity or individual(s)?
- Has anyone given a personal guarantee?
- If an incorporated form, is it limited by shares, guarantee, or is an LLP?
Key Point Checklist
This article has covered the following key knowledge points:
- Incorporated businesses acquire separate legal personality when registered (company or LLP).
- Unincorporated businesses do not have separate legal personality, and their owners are personally liable.
- Limited liability restricts shareholders’ or members’ liability, usually to their capital or guarantee agreed.
- The “veil of incorporation” normally protects members from liability, except in rare cases of fraud or breach of statutory duties.
- Correct party identification is essential in contracts and claims—against the entity where possible, or against proprietors in unincorporated businesses.
Key Terms and Concepts
- incorporated business
- unincorporated business
- separate legal personality
- sole trader
- partnership
- unlimited liability
- limited liability
- company limited by shares
- limited liability partnership (LLP)
- company limited by guarantee
- veil of incorporation
- Companies House
- personal guarantee