Limited Liability Partnerships (LLPs) have become a popular choice of business structure, offering the combined benefits of a traditional partnership but with limited liability. LLPs are particularly popular for firms providing professional services, such as, solicitors, accountants and consultants. They are also regularly used within healthcare, real estate, venture capital, technology and the film and entertainment industry. While the limited liability aspect shields members from personal liability for the partnership’s debts, an insolvency situation can expose members to certain risks, including implications for their personal financial stability. LLP members are frequently not aware of the potential risks associated when forming an LLP, so it is advisable to gain a clear understanding of these risks upfront, to avoid finding out the hard way…
Limited Liability and Insolvency
One of the primary attractions of an LLP is the limited liability protection it affords to its members. Unlike a traditional partnership, where partners can be personally liable for the partnership’s debts, members of an LLP are generally only liable to the extent of their capital contributions to the partnership. However, this limited liability shield can be eroded if the LLP becomes insolvent.
Risks for Members When the LLP is Distressed or Insolvent
- Repayment of Drawings: Drawings by a member refer to the amounts withdrawn by members from the partnership, usually in anticipation of profits, that can only be calculated at the end of the financial year. Drawings are often confused with ‘salary’ and that is where the danger lies. If during the year, one or more members have taken out more money than their end of year profit share entitlement, this excess amount is treated as repayable to the LLP. In an insolvency scenario, liquidators of the LLP will seek to recover these drawings in excess of the member’s profit share to distribute to creditors.
- Where there are no Profits: The same applies if members took drawings in years where the LLP did not even make a profit. A liquidator may also request these to be repaid. Having to return previously withdrawn funds – possibly withdrawn a few years before – could impact individual financial stability. It underscores the importance of a carefully managed drawings policy and adhering to the agreed profit distribution mechanisms. A carefully worded LLP agreement can help reduce (but not eliminate) the risks.
- Unpaid Capital Contributions: Members who have not fully paid their agreed-upon capital contributions to the LLP could be required to meet the unpaid portion. This is always the case in the life of an LLP but often not enforced by the members. However, if the LLP becomes insolvent, the liquidator will look to the member to make up the shortfall.
- Tax Liabilities: Insolvency can trigger complex tax implications for both the LLP and its members. If the LLP does not pay HMRC for certain tax debts prior to liquidation, HMRC may look to the individual members.
- Clawback of Payments to Members: Not only can a liquidator look to recover drawings in excess of a profit entitlement but can also seek to recover other drawings or payments made to members (or on their behalf / to their families / for their benefit) in the run up to the liquidation. The objective of the liquidation is to gather the LLP’s assets (tangible assets or assets such as claims) and seek a distribution of recoveries amongst creditors. The provisions relevant to LLPs are similar to the “wrongful trading” provisions that apply to companies and so there are certain hurdles that must be overcome for a liquidator to establish a claim to claw back sums from a member. One of these hurdles is that the potentially challengeable payments must be within the 2 years prior to the liquidation and that the members must have known, had reasonable grounds for believing or ought to have known, that at the time when the payments were made to them, the LLP was unable to pay its debts and there was no reasonable prospect of the LLP avoiding insolvent liquidation. Those claims are difficult to prove, but are another tool available to liquidators of an LLP seeking to claw sums back into the insolvency estate’s pot.
Conclusion
It is common to not plan for all eventualities when setting up a business. However, it is particularly important for members of an LLP to understand how they work. Generally, there are no “salaries”, only an entitlement to a piece of the profit pie at the end of the year – if there even is a pie left. That is why, especially in these challenging times, it is crucial for members to stay informed about the financial health of the LLP and monitor drawings, because the liability of a Limited Liability Partnership, is not always that limited!