During establishment of a business, selection of the structure is among most decisive steps. Entrepreneurs, those offering professional services, and service-based startups are choosing a Limited Liability Partnership (LLP) more and more often. It provides flexibility in the operation of a partnership and offers limited liability to its members.
However, a fundamental question that may be asked by partners, investors/creditors of an LLP is, ” Who bears the debts of an LLP? The article discusses the mechanics of debt responsibility in an LLP, the instances in which partners are held liable, and the role the structure plays in safeguarding your personal possessions.
What is an LLP? And How Does It Work?
A Limited Liability Partnership Registration is a legal entity established by two or more persons who join together to do business. Unlike a regular partnership, the LLP is no longer synonymous with the partners. This is taken to imply that the LLP is able to enter into contracts, own property, sue and be sued in its own name.
The most notable characteristic of an LLP is the fact that the partners have no personal liability for the debts of a business except under special circumstances under the law. This limited liability enables other professionals like lawyers, consultants, architects, and accountants to partner without exposing their personal assets more than the amount they are bound to contribute in the partnership.
Who Pays the Debts of an LLP?
In normal situations, it is the LLP itself or the entity that is supposed to pay its debts. Because LLP is an independent legal entity, the creditors have to recover their dues by suing the business and not the partners. The financial obligations of the LLP are paid by utilising its assets such as bank accounts, receivables, inventory and other property.
The partners in an LLP are usually not personally liable for the debts of the firm. They only have limited liability with regard to the extent to which they invested or were to invest in the business. In case the business incurs too much debt and it goes insolvent, the partners do not have to meet their personal savings, property, among others, to settle the debts, except in the event of some exceptions.
When Can Partners Be Held Personally Liable?
In spite of the liability-limiting essence of LLPs, there are circumstances in which a partner may become personally liable for the business debts. These are exceptions that should not be ignored if you are thinking of becoming an LLP or a partner in the LLP.
1. Personal Guarantees
When a partner gives a personal guarantee on a loan or lease, they will be personally liable for the particular duty. In this scenario, the partner is in danger of having their personal assets, including house, car or bank savings, pursued by the creditor in the event of default of the LLP.
Lenders and banks will usually insist on personal guarantees where the LLP has only a short credit history or where its assets are not sufficient to support the loan. Signing an agreement of that kind waives the cover of limited liability.
2. Fraud or Misrepresentation
The courts can pierce the corporate veil when a partner of the company commits fraud, misrepresents a fact, or keeps the company operational even when he knows that the company cannot afford to cover its debts (wrongful trading). The legal suit will enable them to sue the partner who commits the offence.
The fraudulent activities could involve the falsification of the financial statements, engaging in too much debt without an honest intention, or spending the organisation’s money. When this happens, the liability of the partner may be unlimited, and the individual assets of the partner can be forfeited to cover the debt.
3. Violation of Legal Liabilities
There are some legal obligations of a designated partner in LLP, e.g. filing the annual return, keeping financial accounts and compliance with regulations. In case they fail these obligations and this results in losses to creditors or other parties, they are personally liable in some situations.
How Are LLP Debts Paid in Case of Insolvency?
When an LLP fails to pay its creditors, it becomes insolvent. In this, the LLP can undergo a liquidation or winding-up process. In the process, assets of the firm are sold and the proceeds shared with the creditors in a legally prescribed order.
Priority is given to secured creditors such as the banks with a charge over the property of the company. Next are the preferential creditors, like employees, who have to be paid their salaries. Lastly, the funds that still remain are applied to pay the unsecured creditors.
In case the assets of the LLP are not enough to pay off the debts, the unsecured creditors may receive only some money or nothing at all. Nonetheless, the partners do not have any personal liability to fill the deficit, unless by way of signing personal guarantees or by way of involvement in fraud.
What Happens to Partner Capital in an LLP?
Although the partners will not assume business liabilities beyond their stake, they face the risk of losing the capital they invested in the LLP. As an illustration, when one of the partners puts in 5 lakhs and the LLP collapses, this money will be lost. It is also a form of capital, thus becomes part of the assets of the LLP, and it will be utilised to pay existing debts when the LLP is liquidated.
Ideally, they risk losing that which they invest in, but no further– unless covered under an exception to liability clauses. This makes LLPs favourable to people who wish to enjoy the tax benefits of association without risking their own finances to a great extent.
Can Creditors Sue LLP Partners Directly?
Under the majority of the circumstances, LLP members cannot be sued by the creditors personally in relation to such business debts. Their suit should also be targeted at the LLP as an organization. Protection of the limited liability in business means that the creditors can not sue the partners in their personal capacities to pay their debts in the business, except that they have special legal reasons to do so.
In an attempt to cover themselves, most lenders will append default clauses or seek personal guarantees in contracts. This makes sure that they have a legal channel in case the LLP goes insolvent or defaults.
Advantages of Limited Liability in LLP
One of the best advantages LLPs have is that it is a limited liability entity. It gives entrepreneurs a peaceful mind, allowing them to pursue risky businesses without jeopardising their personal property. This facilitates the ease in attracting partners, collecting cash and operating across situations that demand common experience.
Tax flexibility, ease of compliance and freedom to run the business without much government interference are also provided in LLPs. The LLP structure would serve as a perfect solution to those professionals who wish to work with one another without exposing themselves to unlimited liability.
Conclusion
In conclusion, the LLP itself becomes liable to pay off its debts and not individuals. This liability protection makes it an intelligent option among professionals, start-ups, and joint ventures. Noticeably, however, it is important to note exceptions to that shield, which include personal guarantees, fraud, and inefficiency, that can cause that shield to be lifted, leaving partners in dangerous personal situations.
Before deciding to form an LLP or join one, visit a legal advisor, and he/she will advise you on the financial liability of LLPs. Write powerful contracts, avoid asking for personal guarantees when possible, and maintain clear business practices. When run in the right way, an LLP can provide legal security and stability in terms of monetary security.
