Crafting LLP agreements

When joining a limited liability partnership, it is essential to secure a written agreement, warns Peter De Maria

As an employee in an accountancy firm being offered promotion, when asked to become a member of a limited liability partnership (LLP), it may seem like a no brainer when the tax advantages, career progression and remuneration on offer are the primary considerations. However, there are significant downsides that people may not realise when giving up their employee status and they need to be weighed in the balance.

LLPs or limited liability partnerships are a cross between a company and a partnership, offering the benefits of limited liability but allowing members the flexibility of organising their structure as a traditional partnership.

LLP members are self-employed for tax purposes and, therefore, save the business the cost of employer's national insurance contributions (NICs). In addition, an LLP member also obtains the cashflow benefit of a delayed payment of tax compared to an employee taxed under PAYE. The flipside is that an LLP member has fewer protections in law if things go wrong.

LLP agreements

Rather than an employment contract, an LLP member's rights and obligations are based on the terms of an LLP agreement. The agreement will govern the relationship and it must be considered with care as the provisions can leave the individual without much legal protection.

The agreement will record what has been agreed about the internal workings of the LLP. Among other things, it will cover profit-sharing, admission of new members, management and decision-making, retirement and expulsion, and the entitlements and obligations of outgoing members. It also includes confidentiality obligations and restrictive covenants to protect the business when members leave.

An LLP member may be an equity member who has invested capital in the LLP and is to receive a share of profits. Or a fixed share member who has a fixed share of the equity and guaranteed minimum drawings of the LLP.

Legal precedent

In the recent case of Tiffin v Lester Aldridge LLP [2012] EWCA Civ 315, the courts looked at the status of a fixed share LLP member. Mr Tiffin was a fixed share partner who was remunerated by way of a small fixed share of profit; he was entitled to extra profit based on a number of profit points; he contributed some capital and had voting rights.

He unsuccessfully claimed employment rights and alleged unfair dismissal. Had Mr Tiffin been paid by way of a fixed share of profit without contributing capital and without voting rights, the result may well have been different. It is now clear that the status of individuals within an LLP will depend upon what was intended at the time of joining, ie, whether or not a relationship of partnership or akin to partnership was to be created. The starting point will often be the member's agreement and any relevant documents from the time of joining.

In the case of Bates van Winkelhof v Clyde V Clyde & Co LLP [2012] EWCA Civ 1207, an equity member of an LLP sought to claim worker rights, arguing that she was protected by whistleblowing laws when she was expelled from the LLP, allegedly for blowing the whistle. The Court of Appeal dismissed her claim, deciding that she was not a worker and leaving her unprotected. Ms Bates' appeal to the Supreme Court is to be heard in March 2014.

Member rights

While LLP members do not qualify for many employment protection rights, they do have similar rights to employees and other workers not to suffer unlawful discrimination on the grounds of race, sex, age, sexual orientation, religion or belief and disability.

A common area for dispute, not surprisingly, is money – both in terms of what the member must put in, their entitlement to profit and their rights on leaving, such as repayment of capital, payment of their profit share, repayment of loans and payment for their share of the goodwill. These aspects will often be covered in the LLP agreement.

It is also important to check the restrictive covenants that apply to an individual when they leave. These can be more onerous than those that apply to employees. For example, there may be a clause that restricts the individual from poaching or dealing with any of the clients of the LLP for a year after their departure from the LLP in contrast to a restriction that is limited to only those clients that the individual had personal dealings with.

Member of LLPs, being self-employed for tax purposes, often overlook the fact that on a negotiated exit they are not entitled to the £30,000 tax-free exemption which is only available for those who are taxed as employees.

Expulsion grounds

As you can imagine, problems commonly arise when members want to force another member to leave. An LLP member cannot be required to leave unless the agreement includes a power of expulsion, even if there are good grounds for forcing them out.

Therefore, it is important that before becoming a member, an individual reviews the LLP agreement and makes themselves familiar with any clause covering the expulsion grounds that the LLP may rely upon such as incapacity, bankruptcy or gross misconduct.

Expulsion clauses have to be complied with by the LLP, otherwise the individual may challenge it on grounds that:

  • the procedure has not been followed;

  • it was discriminatory;

  • it was done in bad faith; or

  • the grounds that the LLP relied upon do not justify the expulsion.

LLP agreements should also include a compulsory retirement clause which allows the LLP to require a member to retire after a set period of notice for no particular reason. Retirement will generally mean that the member receives more notice and is entitled to more money on leaving than is the case with expulsion.

For example, take a case of several members considering that one of the others is not performing to the required standard and wanting them to leave. The agreement will need to be looked at to see what it says about retirement and expulsion. Misconduct will normally be a ground for expulsion but, depending on how misconduct is defined, it may not cover a member not pulling his weight.

Likewise, if expulsion has to be agreed by all the other members, it will not be possible if one of the other members does not agree.

If expulsion is not an option, then the retirement provisions will need to be considered. If there is no express term, the LLP's options for forcing a member to leave are limited. It can agree terms for a voluntary retirement but cannot simply take the individual's share – he is entitled to be paid his share. In the absence of any LLP agreement provisions and where no agreement can be reached, the only way to remove the member is the drastic step of winding up the business.

The case of Eaton v Caulfield Search LLP [2011] EWHC 173 provides a good example of this. When the relationship between Mr Caulfield and Mr Eaton deteriorated, Mr Caulfield sought to expel Mr Eaton from the LLP with immediate effect. However, the court decided that the expulsion was invalid as no power of expulsion had been agreed between the LLP members. As a result, the court ordered the other LLP members to buy out Mr Eaton's share in the LLP and Mr Eaton was entitled to have the LLP wound up.

When disputes do arise which cannot be resolved, litigation may be the only course. However, LLP agreements often require disputes to be resolved in private by arbitration or mediation.

There are obvious advantages to joining a limited liability partnership, but it is important to understand the consequences of changing from employee to partner and not to overlook the potential hidden dangers. Individuals should consider if becoming an LLP member is appropriate and whether it will benefit them in the long run.

Further changes on the horizon

At Budget 2013, the chancellor announced that the government would consult on changes to two aspects of the tax rules on partnerships in order to prevent tax loss arising from:

  • disguising employment relationships through limited liability partnerships; and

  • certain arrangements involving the artificial allocation of profits and losses among LLP members.

These changes are being implemented by the Finance Bill 2014 which is currently making its way through parliament. The Bill provides that LLP members are deemed to be employees for income tax purposes, rather than self-employed, if they perform services for the LLP in return for fixed remuneration (ie, a 'disguised salary'), they do not have significant influence over the LLP's affairs and their capital contribution to the LLP is less than 25% of the 'disguised salary' for the relevant year. This change will take effect from 6 April 2014.

There are also provisions designed to counter the allocation of excess partnership profits to non-individual partners and to counter the allocation of excess partnership losses to individual members. These provisions will have effect for accounting periods beginning on or after 6 April 2014.

Peter De Maria is a partner at employment law firm Doyle Clayton


Peter De Maria |Partner at employment law firm, Doyle Clayton

Peter De Maria is a partner at employment law firm Doyle Clayton and specialises in negotiating sensitive and confidential departure...

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