Peter Weiss and Oliver Grimes of Davenport Lyons offer an insight into the legal issues connected with using limited liability partnerships structures (LLPs).
A growing number of professional practices are feeling the impact of the credit crunch and some are slipping closer to insolvency or simply to needing to take drastic steps to cut overheads, including removing or forcing the retirement of their members.
Many of these professional partnerships have been structured using limited liability partnerships (LLPs), a relatively new form of business entity introduced by the Limited Liability Partnership Act 2000.
While these structures were set up to limit the exposure of members to liability that they faced as members of a general partnership, these LLPs are not immune to the stresses and strains of the current market. Many members who are part of such LLPs may be thinking of other options available to them, and in particular may want to jump ship and look to develop their practices elsewhere.
However, there are a number of issues they will need to consider before they go which may help them consider the best way to exit and the risks they face when they leave.
Potential pitfalls
There are several potential pitfalls for the partners (also known as members) of an LLP in these circumstances.
Firstly, it is important to remember that an LLP is a corporate body with a legal personality separate from that of its members. However, while an LLP contracts in its own name and in most cases shields members from liability, there are a number of ways that members can face personal liability.
In particular, the Limited Liability Partnership Act (LLPA) contains provisions that can require members to contribute to the assets of the LLP upon a winding up.
The current legislation contains new provisions on ‘claw back’ which direct that any amounts that have been withdrawn by a member in the two years prior to the start of a winding up can potentially be clawed back if the member in question knew or ought to have concluded that there was no reasonable prospect of the partnership avoiding entering insolvent liquidation (after he or she had made the withdrawal and any withdrawals contemplated by them at the time).
Further, the definition of withdrawals is drafted to include repayments of loans, salary, interest, profit distribution or transfers of property. Therefore, members of an LLP on the edge can not ‘bank’ on money they have withdrawn from the LLP in the two years prior to leaving.
Members should also take care to review their LLP agreements which may contain contractual obligations on them to help fund up or provide for any shortfalls in the LLP agreement and also will regulate their rights and restrictions on exit. Simply because an agreement does not exist, it does not assist the exiting member as the LLPA regulates for the type of notice required and can also make a member who seeks to leave the LLP improperly be accountable to the LLP for any profits they generate upon leaving it.
Members need to consider carefully how they exit, the notice they give at the time of departure and the best ways to recover any capital or other loan finance they may have advanced to the LLP while they were a member. The primary objective of most exiting members is just to ‘get out’ and as a consequence they may not be considering all the issues, and their consequences, fully.
Tax liability
One key issue which is often overlooked by individuals when exiting an LLP is how their tax liability for profits will be met for profits generated while they were members.
Individual members are taxed as partners, each being liable for tax on their share of the income generated by the LLP.
For individuals looking to jump before the ship sinks, this issue should be given some very careful consideration. It is common, when negotiating the exit of an individual, for a LLP to retain a sum of money (rather than pay it to the individual as part of a severance package) in order to meet the member's tax liability. This route is often chosen by the LLP to improve the short-term cash flow of the firm.
The intention in these circumstances is that the tax reserve money that is withheld at the date of exit will pass on to HM Revenue and Customs on behalf of the member (even if he/she has left) at the relevant time.
However, if the LLP is in a difficult financial state and subsequently becomes insolvent a few weeks or a few months after the individual has negotiated his or her exit, then a significant problem arises. There is no money available within the LLP to meet the outgoing member's tax liability, but the member remains liable to pay it.
Although members may feel protected under the shelter of a limited liability partnership, there are several areas where they find themselves in difficult financial situations after they thought they had successfully exited from an LLP and should take proper advice before going.
The current economic climate shows no signs of abating in the near future and many professionals will be considering their next move. The area surrounding LLPs is complicated and while many are drawn to joining LLPs for the simplicity of their structure, any exit from them is likely to be complicated in the present market.