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A crackdown on tax benefits for LLP members

About The Author

Chris Bridges (Executive Editor)

Chris is an IT and Data Protection solicitor at a top 20 full service firm and the founder of Keep Calm Talk Law. He also contributes to Computers and Law and other sector specific publications.

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In December 2013 a draft of the Finance Bill 2014 was published, the consultation of which closed at the beginning of this month (4th February 2014). This bill, among other things, includes reform to the treatment of salaried members of a limited liability partnership. While this may seem trivial at first glance to an aspiring lawyer, the implications for law firms’ cash flow, partnership structure, and equity partners themselves are great.

The intention of the changes is to limit the category of partner that can operate as ‘self-employed’ rather than as an employee of the firm. A self-employed member of a firm derives significant tax advantages from this status, as does the firm itself.

A self-employed member has a significant ability to obtain tax breaks for expenses, far beyond that of an employee of the firm. Such expenses can range from travel costs (car purchase, fuel, train season tickets etc.), to far more significant tax breaks on finance for business purposes. Meanwhile, the firm itself is not required to make national insurance contributions for a self-employed member.

The changes made by the Bill

The relevant changes can be found in Schedule 1, Part 1 of the draft legislation(page 594 of the document). Changes are made by way of amendment to the Income Tax (Trading and Other Income) Act 2005. Section 836A provides that if all of the conditions in Section 836B are met, the member is to be considered an employee under a contract of service for tax purposes rather than a member of the partnership. Those conditions are:

863B Conditions A to C

  1. Condition A is that there are arrangements in place as a result of which – 
    1. at or after the time at which it is being determined whether the condition is met, M is to perform services for the limited liability partnership in M’s capacity as a member of the partnership, and
    2. it is reasonable to expect that the amounts payable by the limited liability partnership in respect of M’s performance of those services will be wholly, or substantially wholly, disguised salary.
  2. An amount is ‘disguised salary’ if it –
    1. is fixed,
    2. if it is variable, is varied without reference to the overall amount of the profits or losses of the limited liability partnership, or
    3. is not, in practice, affected by the overall amount of those profits or losses.
  3. In subsection (1) ‘arrangements’ includes any agreement, understanding, scheme, transaction or series of transactions (whether or not legally enforceable).
  4. Condition B is that the mutual rights and duties of the members of the limited liability partnership, and of the partnership and its members, do not give M significant influence over the affairs of the partnership.
  5. Condition C is that, at the time at which it is being determined whether the condition is met (‘the relevant time’), M’s contribution to the limited liability partnership is less than 25% of the amount given by subsection (6).


The Effect

First, not all law firms will be affected to the same extent under this move; it really depends on how a firm structures its partner remuneration. Second, as all three conditions must be met, some categories of partner may automatically be safe from these changes. Therefore, I shall cover the effect on each category of partner below.

Salaried Partners

Salaried partners receive a salary, and often have a bonus to top this up linked to the profitability of the firm in a given year. Salaried Partners in most cases will have no stake in the business, and therefore are not required to ‘buy in’ to the partnership by putting up a capital investment. Consequently, salaried partners will usually have limited voting rights, if any.

Therefore, salaried partners will be unaffected by this move, as they are already considered employees of the firm.

Fixed-Share Partners (Quasi-Equity Partners)

Fixed-Share Partners, often known as Quasi-Equity Partners, receive a fixed amount of profit per year (i.e. £150,000) and are considered an ‘owner’ of the partnership. Therefore, they will in most cases be required to ‘buy in’ to the partnership by offering up capital. The amount of capital required varies from firm to firm, and even within the firm, different partners with different stakes will likely have different capital requirements.

This category of partner is most likely to be affected by these changes. First, as their stake is fixed and unrelated to profits, they are captured by Condition A as having a ‘disguised salary’. Second, it is unlikely that their voting rights will be enough to exert ‘significant influence over the affairs of the partnership’, therefore being captured by Condition B also. Condition C will vary from firm to firm, depending on the capital requirements they have in place. For those fixed-share partners that have paid in less than 25% of their annual share, Condition C will also be satisfied.

Full Equity Partners

Full equity partners receive a percentage share of the firm’s profits, which is therefore directly related to profits, and cannot be considered a ‘disguised salary’ under Condition A. As all three conditions must be fulfilled for these provisions to take effect, full equity partners are in the clear.

Regardless, full equity partners may or may not have ‘significant influence’ over the firm under Condition B, depending on how significant influence is interpreted. My reading would be that having voting rights is an influence, and being a board member would be a significant influence. Therefore, I suspect the majority of partners in larger firms would be captured by Condition B.

Again, Condition C varies between law firms, and as a full equity partner’s share is not fixed, it could, in theory, vary dramatically from year to year. However, as all three conditions must be fulfilled, this is merely academic.

The Solution

George Bull, Head of Professional Practices at Baker Tilly, has suggested that the ‘least-worst’ option to resolve this issue would be for firms to bolster their capital requirements for partners where they fall short of the 25% mark. The logic behind this is clear. Avoidance of Condition A would require making all partners full equity partners, which in many cases would simply not be appropriate and would incur a substantial structural change. Avoidance of Condition B could be even harder, as even most full equity partners are unlikely to be considered as having ‘significant influence’ over the firm.

However, even changes in capital buy-in requirements are not a quick fix or easy solution. The majority of partners will advance this capital by utilising a bank loan, often arranged by the firm on preferential terms, but in the partner’s (not the firm’s) name. Bull suggests that firms will be hard pushed to re-arrange finance in such a short time frame in any scenario, even if every other firm was not doing the same. He has therefore urged HMRC to provide a period of grace and to provide confirmation that altering capital requirements in order to maintain the self-employed status will not be considered tax avoidance.

Some firms may have even bigger issues. Olswang for instance has an unusual partnership structure, with only one category of partner that is neither fixed-share nor full equity. Their remuneration structure is entirely meritocratic based on “client contribution, internal contribution, external contribution and performance”. As such, criteria cannot be pegged to actual profits; all partners will be affected by these changes if they are not able to re-arrange capital and finance in time.

As noted in the opening paragraphs above, if firms are unable to make these capital changes and are therefore affected, both individual partners and firms are set to lose out. For firms that are experiencing cash flow issues, this is an even greater problem. An unexpected and unplanned for increase in their national insurance bill could push them over the edge into insolvency. Manches recently experienced this fate due to a VAT bill; a potent reminder that this could very well be a possibility for financially challenged firms.

Problems Remain

Even if firms are able to make changes in time, is this really a desirable position? Higher capital requirements will force many partners to take a much greater financial risk by increasing their personal liabilities. Could this affect eager solicitors’ aspirations of becoming an equity partner? Could this put a bar in front of those that do not have a great credit rating or those that otherwise would have a good credit rating but already have extensive debts due to that family home they have just bought?

There is however a clear policy argument behind this. Tax benefits do not come free. For the normal person, the benefits obtained through self-employed status come at a cost of financial instability and/or risk. HMRC, by forcing partners to increase their personal risk, are making partners pay for the benefits they obtain. Why they wish to do this is however unclear. The only real winners are the banks that finance law firms: an increase in capital from individual partners diminishes their risk.

A comparison between an LLP and a limited company is useful here and raises much bigger questions over what tax partners should be paying. While partners provide a service to the firm much like an employee, they are also equivalent to a shareholder in a company. Shareholders who take their share of profits by virtue of a dividend pay a much lower rate of tax than they would as an employee. In fact, many contractors set themselves up as a one-man limited company, pay themselves a nominal salary as a director, and take the majority of their profits out through dividends. The same can be applied to companies set up by several persons; the company pays a nominal salary and the rest via dividends according to the size of their shareholding.

Why should a company shareholder have the privilege of paying a much lower rate of tax, where a partner cannot even operate under self-employed status? Perhaps this could be the incentive many firms need to convert to a limited company under an ABS…

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Tagged: Legal Business, Tax Law

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