Most LLP agreements pay careful attention to how profits are shared. Far fewer give the same thought to what happens when there are losses. That omission can have serious consequences for members; consequences that are, with proper drafting, entirely avoidable.
The Problem With Automatic Loss Allocation
A limited liability partnership is, as the name suggests, a structure designed to limit the personal liability of its members. In most circumstances, that protection holds. However, where an LLP agreement automatically allocates losses to members’ capital accounts, those members may find themselves exposed in a way they did not anticipate, particularly if the LLP subsequently becomes insolvent.
When losses are allocated directly to a member’s account, they reduce or eliminate that member’s capital balance. If the balance becomes negative, the member may be treated as owing money to the LLP. In a liquidation, the liquidator may seek to recover that sum. What was presented as limited liability can, in practice, become a personal debt.
This is not a theoretical risk. Liquidators are under a duty to recover assets for creditors, and a negative capital account is an asset of an insolvent LLP.
The Solution: A Loss Reserve Account
The answer lies in how the LLP agreement is drafted. Rather than allocating losses directly to members’ accounts, the agreement can direct that losses are credited to a loss reserve account which is a separate ledger entry at the LLP level, rather than at the individual member level.
The loss reserve account absorbs the loss within the LLP’s own accounts. Members’ individual capital accounts remain unaffected. Future profits could then be used to reduce the loss reserve before any distributions are made to members, preserving the commercial logic of the arrangement whilst protecting members from personal exposure.
This is a well-established mechanism in partnership accounting, but it is, in my experience, absent from the majority of LLP agreements I review. That is a significant gap.
What Good Drafting Looks Like
An LLP agreement that addresses this properly should:
- Define clearly what constitutes a loss for the purposes of the agreement;
- Provide that losses are credited to a designated loss reserve account rather than allocated pro rata to members’ accounts as a default;
- Set out the order in which future profits are applied, typically, to reduce the loss reserve before any surplus is distributed;
- Address what happens to the loss reserve on a member’s retirement or the dissolution of the LLP;
- Consider whether, and in what circumstances, members may be asked to contribute to making good a loss reserve, and ensure that any such obligation is clearly defined and limited; and
- Set out in what circumstances the loss reserve may be credited to members’ accounts and what the decision making requirement are for that to occur. It typically happens when members have profits elsewhere they need to offset.
The precise mechanics will depend on the nature of the LLP’s business and the commercial agreement between members. There is no universal template. But the starting point should always be that losses do not automatically flow through to individual members.
Why This Matters
When the economic climate looks more challenging, professional partnerships are not immune. An LLP that encounters financial difficulty will have enough to contend with, without members facing the additional burden of personal liability arising from drafting that nobody thought to challenge when the LLP was formed.
Reviewing your LLP agreement costs relatively little. Failing to do so, and discovering the gap in a liquidation, can cost a great deal more.
We Can Help
At Bennett Briegal LLP, we advise on the formation, structuring and governance of LLPs. If you would like us to review your LLP agreement, or if you are establishing a new LLP and want to ensure the structure is right from the outset, please do get in touch.
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