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How will the new guidance on limited liability partnerships (LLPs) affect the way law firms operate? Andrew Allen, partner and specialist in the legal sector at Francis Clark, Chartered Accountants looks at the implications of the new guidance for both LLPs and individuals.
Following consultation, HMRC has revised its guidance on the draft Finance Bill legislation containing the limited liability partnership salaried members rules, which will treat members as employees where three main conditions are met. Legislation for the 'disguised salary' condition (condition A) will now make explicit the 80% threshold for the condition to apply. The capital contribution condition (condition C) will now take into account a firm commitment to contribute capital within three months of 6 April 2014 (two months where the member joins on or after 6 April) when deciding whether the 25% condition is met.
How will the new rules on LLPs impact law firms?
From 6 April 2014, in order to remain self-employed, a member of an LLP must avoid meeting at least one of three specific conditions. These concern whether there is a disguised salary (Condition A), whether the member has significant influence (Condition B) and what level of capital the member has at risk (Condition C).
Condition A is met where a member’s income is substantially fixed. For a member to not be caught by this condition their profit share must be both linked and directly related to the overall profits of the firm. It is designed to identify arrangements that are akin to employment with a salary based on personal performance. The rules focus on what a member could reasonably expect to receive. There are a wide range of examples in ‘Partnerships: A review of two aspects of the tax rules Salaried Members Rules: Revised Technical Note and Guidance’ (the Guidance) issued by HM Revenue & Customs (HMRC) on 21 February 2014 on how disguised salary could be assessed. Most are broadly common sense interpretations of similar themes and clearly highlight the obvious avoidance tactics firms might seek to put in place.
Condition B is based on more traditional self-employment tests. It is designed to identify where an individual is clearly involved in the management of the LLP. It has its roots in the original consultation document from 20 May 2013 but has been developed further since and is the most expanded upon in the Guidance. There are some good practical examples in the notes of what constitutes significant influence. It particularly highlights the fact that smaller firms are more likely to be able to demonstrate that more members have significant influence than larger firms. This is to be expected. Overall, this condition is worth more attention for many LLPs (say sub 15 member firms) rather than immediately turning towards capital injections.
Condition C is designed to identify where a member has significant capital at stake in a business such that he or she is exposed to material financial gain or loss. As long as capital of at least 25% of the disguised salary is contributed then Condition C is not satisfied. Note that it is capital in the LLP that matters and not current accounts or tax reserves etc.
The Guidance changes the previously announced draft legislation slightly and adds considerable further detail including many practical examples and interpretations. While, much of this document largely confirms what was originally understood, it does rule out some extreme interpretations. It does contain considerably more detail on Condition B (significant influence) although it is possible that that condition in particular may be subject to more debate as the measure goes through Parliament. While the measure is effective from 6 April 2014, there will not be complete certainty until Royal Assent is obtained on the Finance Bill in July 2014. Despite this, the substance of the measure is not expected to change.
What practical suggestions do you have for firms or managers in regards to addressing the change effectively?
The starting point for most law firms is to examine their underlying arrangements with all their partners to identify whether an issue potentially arises in respect of their self-employment status. If problems are deemed to arise then the next decision is whether the LLP and/ or the members themselves are keen to preserve self-employment status or not.
If they are, then examining which ‘condition’ should be focused on is the next step. If self-employment status is not going to be retained then a consideration of the practical issues—cash flow and employment arrangements—need to be considered by the law firm and the member.
Are firms concerned about the changes? Will this affect the tax status of firms?
Firms are clearly very concerned about the changes because it creates a great deal of work in terms of reviewing arrangements and in many cases will ultimately mean a choice between existing members being required to provide additional capital to the LLP or become employees again—the latter having a negative cash flow impact on the law firm.
If members return to employment status this may have a very great financial impact on an LLP. This will depend on:
• whether there are fixed share members
• the number of equity members
• the terms of the LLP agreement, and
• the level of profits being generated
Some LLPs currently have a large number of members on fixed shares who have made a modest capital contribution.
In view of the potential financial impact on the LLPs affected, those firms need to consider whether this tax change will apply to them and whether they have salaried members within the terms of the legislation. Those firms need to consider the conditions in detail. There is a targeted anti-avoidance rule to be introduced as part of the new legislation in Income Tax (Trading and Other Income) Act 2005, s 863C(1) (ITTOIA 2005). In the Guidance (para 3.1.1, pg 42) HMRC confirm that the TAAR would not apply on a ‘genuine and long-term restructuring that causes an individual to fail one or more of the conditions’.
Are firms welcoming of the changes?
For most law firms this is an unwelcome distraction from commercial matters at a time when the sector is seeing the first glimmers of upturn since 2007. Most firms who have an issue in this area are focusing on the level of capital contribution (Condition C). Smaller firms could well be served by considering Condition B (significant influence) although by its nature this seems to be a more subjective measure for firms to rely upon and is currently proving less favourable.
Are the changes likely to be effective in curbing tax avoidance and abuse of the partnership status?
The changes remove an unusual difference that has existed between LLPs and unincorporated partnerships. In LLPs there is currently an automatic assumption of self-employment for members. In contrast, in an unincorporated partnership there is a requirement for partners to demonstrate they are self-employed.
The proposed legislation here was not originally aimed at professional partnerships but large businesses who were abusing the self-employment status in LLPs by transferring their entire work force en masse to become members of the LLP rather than employees saving considerable levels of Employers National Insurance in the process. The legislation to this extent is likely to be successful although for most law firms if they are prepared to modify their arrangements it remains perfectly possible for members to retain their self-employment status.
The current draft legislation also needs to be seen in the light of a number of recent tax changes impacting on partnerships. In part this is prompted by limiting the capacity for tax avoidance schemes. However, this measure suggests a broadening of approach. The other recent measures include changes to the loans to participators rules in Finance Act 2013 (FA 2013), the potential scope of the General Anti-Abuse Rule (GAAR) from July 2013, an announcement restricting the tax relief available on the use of service companies in October 2013, and an Autumn Statement announcement and draft legislation published on 10 December 2013 to limit the use of corporate partners in LLPs and other partnerships.
When will the new legislation be published?
The rules were originally announced by the Chancellor in the Autumn Statement on 5 December 2013 and contained within the draft Finance Bill 2014 legislation published on 10 December 2013. While we do not expect the final legislation to be substantially altered from that currently proposed, the changes announced in the Guidance and the extra guidance issued suggest that some further minor changes are possible as the measure passes through Parliament. Technically of course the legislation will not be fully effective until Royal Assent of the Finance Bill 2014 expected in July 2014.
The current draft legislation also needs to be seen in the light of a number of recent tax changes impacting on partnerships. In part this is prompted by limiting the capacity for tax avoidance schemes. However, this measure suggests a broadening of approach. The other recent measures include changes to the loans to participators rules in FA 2013, the potential scope of GAAR from July 2013, an announcement restricting the tax relief available on the use of service companies in October 2013, and an Autumn Statement announcement and draft legislation published on 10 December 2013 to limit the use of corporate partners in LLPs and other partnerships.
Is it consistent with other trends in the area?
While LLPs are corporate bodies with a greater resemblance to limited companies than to traditional partnerships, specific tax legislation currently exists to ensure that LLPs are treated as partnerships for tax purposes rather than as companies. However tax legislation (specifically ITTOIA 2005, s 863) was introduced to deem all LLP members to be self-employed. This was a policy decision by the government at the time but now many LLP members are considered by HMRC and HM Treasury to be engaged on terms of those of an employee rather than as a partner. This has been possible because the limited liability nature of an LLP means that employees have been prepared to become fixed share partners without much upside because the downside risk is limited. Over the last decade this has enabled large professional partnerships to have an absolute saving in terms of avoiding national insurance and a cashflow benefit as pay-as-you-earn tax (PAYE) does not apply to fixed share partners.
Therefore, in some ways, this proposed change could be seen as re-instating the position that was understood to be the position for traditional partnerships prior to the introduction of LLPs. However, the absence of joint and several liability makes it difficult to apply traditional self-employment tests to an LLP member. In any case, status indicator tests are not easy to apply to partners. A further point is that these new rules may in turn influence case law and practice in this area.
Interview by Diana Bentley. The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.
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