How a Limited Liability Company Affects Creditors

Just when you thought you knew everything there was to know about debt collection and creditor’s rights, along comes the Limited Liability Company with its own set of rules.

On October 1, 1994, Governor Pete Wilson signed the Beverly-Kilea Limited Liability Company Act into law, thereby giving birth to the Limited Liability Company commonly referred to as the “LLP”.

The LLP is not like a corporation and not like a partnership. It is more like a hybrid of the two.

From a tax perspective, the LLP is more like a partnership, in that, except for an annual minimum tax, the business’ earnings are not taxed.

However, like the corporation, the owners of the LLP are not personally responsible for the LLP’s debts and obligations. The remainder of this article will focus on the limited liability aspect of the LLP since that is where creditor’s concerns lie.

The first thing that a creditor needs to know, is how to identify an LLP. The easiest was to identify an LLP, would be to change your credit application/financial statement to include a box to check for an LLP. This would obviously alleviate you having to discover this information on your own.

However, if your credit documents cannot be changed immediately, and you must figure out the status of the business entity you are dealing with on your own, the best thing to do is to examine the name of the entity.

Every LLP is required by law to include the words “Limit Liability Company” or “LLP” or “L.L.C.” in its name. If the name does not include this, they may not avail themselves of the benefits of being an LLP.

As was discussed above, the greatest benefit of being an LLP is the limited liability aspect for its owners. An LLP is very much like a corporation in this respect.

In the event that the LLP becomes indebted to you, you will be limited to seeking repayment from that LLP and may not pursue the owners or managers of that business.

Since we all know that corporations usually go in and out of business faster than it takes the ink to dry on the credit documents, we have no reason to believe that the situation with LLP’s will be any different.

It is for this reason, that I urge you to insist on personal guaranties if you are dealing with an LLP. LLP’s may even present a greater credit risk than corporations.

The theory behind this reasoning, is that since a corporation’s owner has to pay substantial corporate taxes, he is less likely to set it up to be a sham corporation to defraud creditors. It is too expensive.

However, with an LLP, the costs to set the entity up and keep it running are minimal. The reason for this, is because the earnings are not taxed as they are with a corporation. It stands to reason, that if the cost of an LLP is less than the cost of a corporation, more people will form LLP’s and probably more of those LLP’s will be undercapitalized and set up as sham entities to defraud creditors.

It is for this reason, that it is so important to carefully evaluate the business and its principals before extending credit.

Another situation which is certain to become a common place occurrence, is where one of your current customers changes its status to an LLP and fails to notify you of the change.

You may continue to extend credit based on the belief that you are dealing with a sole proprietorship or a partnership with personal liability when in fact the principals have managed to insulate themselves from liability with an LLP. Remember, that any transactions occurring after the business has converted to an LLP will be subject to the limited liability rule.

One way you may avoid this from happening, is to send out letters reminding your customers that if they change their legal status mid way through the credit relationship, they have a duty to inform you thereof. Another way, would be to pay attention to their checks, purchase orders or letterhead, to see if there has been an LLP added to the end of their name.

Although we have always stressed the importance to our clients of getting personal guaranties to secure the extension of credit, we now more than ever believe that this is essential.

The reason for this, is because as LLP’s grow in popularity, they will become the rule rather than the exception. This means that there will be fewer and fewer partnerships because now with LLP’s, people can now get the tax benefits of a partnership with the limited liability of a corporation. Partnerships and sole proprietorships, which expose personal liability, will probably become a thing of the past.

Without that personal guaranty, the LLP can easily close its doors and you as its creditor are out of luck. You have no recourse.

In conclusion, be aware of the consequences of dealing with an LLP, learn how to identify one, and most importantly, insist on a personal guaranty to protect yourself in the event their account goes delinquent. Good luck!