HM Insights

Choosing a partnership model: The Sword of Damocles hanging over partners

In ancient times Damocles wanted to be rich and live the life of a king. His king granted his wish and gave him a marvellous feast where his servants would treat Damocles like a king. However, a sword was suspended over him, held only by a single hair, and could fall on the poor Damocles at any time. While it may be bit far-fetched to compare partners in a partnership with Damocles, partners should nevertheless be aware of the potential precarious situation that they find themselves in.

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Liability of partners

Partners in a partnership have joint and several liability for the debts and obligations of the partnership. Therefore if you are a partner in a partnership with say three other partners and the partnership owes a creditor £20,000, it does not mean that your liability to the creditor is £5,000 (being a proportionate share) but instead you are potentially liable for the full £20,000 to the creditor.

Furthermore where any wrongful act or omission has been committed by a partner acting in the ordinary course of the business of the partnership, then the partnership and ergo each of the partners is liable for that partner's actions. This would seem to be rather penal towards innocent partners who had no involvement in the wrongful act or omission. Unsurprisingly there are many cases where the first line of defence for the partnership and its partners to absolve themselves of liability is that the misbehaving partner was not acting in the ordinary course of the partnership's business.

Perhaps the reason why partnership law imposes such liability to partners is that partners are in a position of mutual trust with each other and as such are fully responsible for their fellow partners' actions so long as they were in the ordinary course.

While this may be fine if you are a small partnership, it may not be appropriate where you are in a partnership consisting of numerous partners or plan to expand the partnership with new partners. Partnerships can of course now consist of more than 20 partners with the historical limit removed in 2002.

To address, primarily, the potential unlimited liability of partners in a partnership, limited liability partnerships (or LLPs) were introduced in 2000. An LLP can be considered a hybrid between a company and a partnership with areas such as default rules for the operation of the LLP, taxation and the operation of capital and current accounts similar to a traditional partnership but matters such as the requirement to make filings at Companies House and insolvency more akin to a company.

Advantages of an LLP

More importantly the liability of members in an LLP is similar to that of shareholders - the members benefit from limited liability as the LLP, being a legal person, will enter into contracts and be responsible for its debts and obligations and not the individuals who are members of the LLP. Furthermore, an LLP has other benefits such as:

  • It is a registered entity with Companies House and therefore will have a registration number and be visible on Companies House online. This is highly desirable if the LLP conducts any international business.
  • Like a partnership it is tax transparent which means that only the members are taxed and the LLP pays no tax. By way of comparison, a private limited company pays corporation tax and shareholders pay income tax on any monies distributed to it.
  • LLPs are not dissolved on the death or bankruptcy of a partner.
  • An LLP has unlimited capacity to contract which means that the other party to the contract does not need to be concerned about signing authority.
  • Where a partnership has entered into a contract, there is a question over the enforceability of that contract by the partnership where there is a change in partners. This is because while a Scottish partnership has separate legal personality it is doubted whether it has perpetual separate legal personality. The change in members of an LLP does not affect any contracts entered into by the LLP.

Disadvantages of an LLP

However, an LLP may not be the appropriate choice for everyone. The main disadvantages are:

  • An LLP is subject to the same registration requirements as a company, while a partnership can simply be formed by two partners intending to carry on business in common with a view of profit with no registration required.
  • After registration, there are ongoing filing requirements which increase the administrative burden.
  • An LLP will have to file accounts at Companies House so its competitors can see how well (or badly) it is doing. Furthermore if the LLP is of a sufficient size, it will incur the additional cost of having its accounts audited.

Therefore it is not automatic that an LLP is the right choice for everyone. However if the partners' main concern is to benefit from limited liability and are prepared to put up with the pain of more administration and costs, and a lack of anonymity, then it is worth considering.

In the same vein, Damocles gladly swapped his fine feast for a sword not hanging over his head.