Insolvent LLPs – The Members Nightmare

LLPs are receiving a lot of attention from the Government at present, and new tax legislation will be introduced to limit some of the tax advantages of operating as an LLP. These changes are likely to give rise to an increase in costs for many LLPs and may result in the LLP restructuring its business and financing or transferring its business to a limited liability company.

Members of an insolvent Limited Liability Partnership (“LLP”) may well face significant personal liabilities. Overdrawn current and capital accounts will have to be repaid to the LLP, together with – potentially – any withdrawals during the two years prior to the commencement of the insolvency. In addition, any unpaid income tax is a personal liability of the members, even if notionally deducted but not paid over to HM Revenue & Customs by the LLP.

This will come as a shock to many members who anticipated that the consequences of an LLPs failure would follow the outcome for shareholders of a limited liability company. After all, an LLP has “Limited Liability”!

A member’s drawings will, for many members, be regarded as their “salary” and may well be paid after a notional tax deduction. However, drawings are in fact an advance in lieu of profits and if the LLP makes no profit, or a member’s share of profits is less than their drawings, or the LLP’s profit is not allocated to members, excess drawings are repayable. If a member’s capital and current accounts together are in credit, after taking into account the member’s drawings, that member will not have a direct personal liability to the LLP. However, any payment to members that was made (i) at a time the LLP was unable to pay its debts, and (ii) during the two years before the formal insolvency began, may be claimed by the administrator or liquidator of the LLP under so-called clawback provisions.

The position may be even worse from a member’s perspective as the income tax liability for members on their share of the LLPs profits is a personal liability. If the amount of tax due is not paid by the LLP for any reason, HMRC will seek to collect the income tax due directly from the member. This is despite the deduction of notional tax at the time members received their drawings.

Clearly, an LLP member’s liability is not as limited as many members might expect.

Two of the perceived advantages in operating a business through an LLP, rather than a company, have been that there would be savings by not having to pay employers’ national insurance contributions on members’ shares of profits, and that there would be cash flow benefits from income tax being paid by instalments, twice a year (rather than through monthly PAYE deductions). In consequence there are now many “fixed profit share” members of LLPs who would otherwise be employees. It is not generally appreciated that these arrangements create a significant potential liability for fixed profit share members which will crystallise if the LLP fails. Fixed profit share members face the same clawback provisions and personal liability for income tax on their profit share as other members on the insolvency of an LLP. Members, particularly those fixed profit share members who may otherwise regard themselves as an “employee”, may well be surprised to know that they have a personal liability if the LLP fails

If the “fixed profit share” members of an insolvent LLP had been employees, their monthly (net) salaries would have been paid after the deduction of PAYE and national insurance and the tax liabilities would be with the employer. Also, they would not be at risk of repaying overdrawn capital and current accounts and there would be no potential clawback of their net pay.

If an LLP is making losses the members need to evaluate the LLPs performance projections to ensure there is profit for members, otherwise member’s drawings may have to be repaid

Although some members may wish to draw comfort from their Members Agreement, this agreement is between the members and the members’ obligations under the insolvency regulations are likely to prevail should an LLP fail.

Whereas this article has been written to illustrate the impact on a member’s obligation to repay excess drawings when an LLP becomes insolvent, there are many other issues that affect members of an insolvent LLP.

Each LLP will be different in its constitution and in its arrangements with its members, and members who are uncertain about the extent of their liability on the failure of the LLP should seek advice on their arrangements with their LLP.

If you would like our advice, do not hesitate to contact us.