Correlation Between Capital Contribution And Profit Sharing Ratio In An LLP
Santosh Singh And Nikita Chhabra
20 Sept 2024 11:57 AM IST
A Limited Liability Partnership (“LLP”) is a body corporate formed and incorporated under the Limited Liability Partnership Act, 2008, (“LLP Act”) and functions as a distinct legal entity, separate from its partners. This separation means that the LLP can own assets, enter into contracts, and be held liable independently of its partners, providing a layer of protection to the personal assets of the partners. An LLP has perpetual succession i.e. it continues to exist regardless of changes in its partnership, such as the departure, death, or insolvency of partners, subject to the terms of the LLP agreement executed between the partners.
An individual or a body corporate may be a partner in an LLP. The mutual rights and duties of the partners of an LLP, and the mutual rights and duties of an LLP and its partners are fundamentally governed by the LLP agreement executed between the partners, or between the LLP and its partners (“LLP Agreement”).
In cases of absence of LLP Agreement or where the LLP Agreement does not address any particular matter concerning the mutual rights and duties of partners or the relationship between the LLP and its partners, the provisions of the First Schedule of the LLP Act is applicable.
Capital Sharing and the Profit and Loss Sharing Ratio
The capital sharing ratio refers to the proportion of capital each partner contributes to the total capital of an LLP. The profit sharing ratio is the percentage of profits (or losses) allocated to each partner in the LLP. The assumption is that the profit sharing ratio should align or be in the same proportion as the capital sharing ratio, i.e., the higher a partner's contribution to capital, the larger their share of the profits. The First Schedule of LLP Act also provides that, if no specific ratios are agreed upon between the partners via the LLP Agreement, the default assumption is that profits, losses, and capital contributions will be shared equally among the partners.
However, in an LLP, contributions made by the partners are diverse and can include tangible, movable, or immovable property, as well as intangible assets or other benefits, such as money, promissory notes, or contracts for services performed or to be performed. The partner's obligation to contribute, whether in the form of money, property, or services, is governed by the terms of the LLP Agreement, they are given greater freedom to decide how they wish to structure their contributions. Partners have the liberty to negotiate and agree on a profit and loss sharing ratio that may be entirely independent of the capital contributions.
Therefore, the capital sharing ratio does not necessarily need to be equal or proportionate to the partner's share of profits and losses. For example, one partner may contribute 70% of the total capital, while another contributes only 30%, and still, the arrangement between partners for sharing the profits and losses may be in the ratio of 50:50 each or such other proportion, depending on the mutual understanding between the partners under the LLP Agreement.
The profit or loss sharing proportion may be different from the capital sharing proportion due to several reasons including additional services provided by the partner etc.
Similar finding was affirmed by the ITAT in the case of JCIT (OSD), Circle-32 Vs. Aditya Kumar Singhania wherein it was held by the Kolkata Bench that “Neither the provisions of the Income Tax Act nor the provisions of the Limited Liability Partnership Act, 2008 anywhere mandate that the partners should receive their share in the profits or losses in the proportion in which the funds are contributed by the partners. On the contrary, it is an universally accepted position that in the case of partnership firm or LLP, it is open for the partners to share the profits and losses in the manner mutually agreed and there is no legal compulsion that profit ratio should be in proportion to the capital contributed by the partners. It is also a pertinent fact that a business is not carried on only with the help of the capital contribution by the partners. The profitability of partnership business substantially depends on the business acumen and efforts contributed by the individual partners.
There is no legal bar in the LLP Act on sharing the profits or losses in the proportion which was different from the proportion in which capital was contributed by the partners.”
This case underscores that the profit sharing ratio i.e. the percentage of profits (or losses) allocated to each partner in the LLP can be structured independently of the capital contributed by the partner in the LLP, thereby allowing partners to share profits in a way that reflects their contributions beyond just financial contributions.
The ability to have differing capital and profit sharing ratios in an LLP is not just a feature of legal flexibility, it is a strategic advantage. By allowing partners to tailor their financial and operational relationships, an LLP can more effectively align the interests of its partners, incentivize contributions beyond mere capital, and optimize the long-term success of the business. This unique aspect of LLPs makes them particularly suited for modern business environments, where the contributions of partners can be as varied as the businesses themselves.
Author: Santosh Singh, Partner and Nikita Chhabra, Associate, ZEUS Law Associates. Views are personal.
