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Insolvent LLP: members’ liability

Members’ liability when their LLP becomes insolvent is not as limited as members may expect. LLP members’ liability is not always limited to their capital contributions.

A failed LLP’s members are not in the same position as a failed limited company’s shareholders.

Insolvent LLPs: members’ drawings trap

Members’ drawings are essentially an advance payment of their profit allocation. The profit allocation is actually paid to members after the financial period.

Generally, members can take monthly drawings that are equivalent to their anticipated share of profits. The drawings are a debit in the member’s account. A debit balance in a member’s account means a debt due to the LLP.

These drawings only becomes the member’s property:

  • At the end of the financial year;
  • After the LLP’s profits are calculated, and
    • Allocated to the members’ account;

Only then does the LLP owe money to the member.

Insolvent LLP risks

Members of an insolvent LLP face risks, depending on which financial year they took the drawings

Financial year in which the LLP insolvency occurs

If the LLP is insolvent, it probably won’t make profits to allocate to the members account. So, the member’s account debit balance, created by the drawings, remains.  This debit balance is a debt, payable by the member, to the insolvent LLP.

Prior financial year

Perhaps, the debit balance created by previous financial year’s drawings has not been cleared. This may be because when the LLP insolvency occurs, the previous financial year’s profits have:

  • Not been determined; or
  • Not yet allocated to a member’s account.

Allocating profits requires more than posting credit balances to a member’s account. Liquidators look for a decision to allocate profits, e.g. a recorded board resolution. Only then might the profit be said to become the member’s property, and reduce the member’s account debit balance.

How LLP members avoid debt

As soon as possible, LLPs should:

  • Determine profits at the end of the financial period;
  • Allocate the profits to the member’s accounts.

Unfortunately, in practice this does not happen quickly. Thus insolvency may occur before the LLP has determined and allocated previous year’s profits.  Then a liquidator can pursue members for repayment of debit balances on their accounts.

This shocks members. Often members regard drawings as “salary”, especially as the LLP withholds tax before payment.

Indemnities

One reliable solution is an indemnity. However, members must negotiate an indemnity, and bind the intended parties with a written agreement.

LLP’s tax reserves

Often LLPs retain part of a member’s profit entitlement to meet the member’s personal tax obligations. However, if these funds are not held in trust, and if times are tough, the LLP uses this money to support the business.

Each LLP member is personally liable for the tax due on their share of profits if the LLP:

  • Becomes insolvent; and
  • Has spent the members’ tax provisions.

However, members may be able to claim terminal loss relief.

LLP trading whilst insolvent

What if the LLP pays members:

  • At a time when the LLP was unable to pay its debts and
  • Up to two years before the formal insolvency began.

Then the LLP’s liquidator might claim these payments back using the Insolvency Act 1986 clawback provisions.  However, the LLP’s liquidator must prove that, on a balance of probabilities, the LLP member knew:

  • Knew of the LLP’s impending insolvency at the time of the withdrawal, and
  • Knew, or ought to have known, there was no reasonable prospect the LLP would avoid insolvency.

The liquidator will consider the demarcation of financial management responsibilities. These responsibilities are defined in the partnership agreement.

LLP members’ personal guarantees

LLP members are liable for any personal guarantee.  Even former LLP members remain bound in their personal capacity, if when ceasing to be a member, they did not release the guarantee.

Conclusions

Events at King & Wood Mallesons shone a spotlight on the consequences of an LLP’s financial failure, and the adverse outcomes for their members.

We work with partners and the partnerships at all stages from set-up, conversion to limited company, to sale of assets or administration.

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