Death of the Salaried Partner? Wide Ranging Changes to LLP Member Taxation To Come Into Force on 6 April 2014

Overview


Wide ranging changes to the way in which LLP members are taxed are due to take effect on 6 April 2014. LLPs and their members, particularly those in professional service and private equity/fund management firms, should, therefore, consider the impact of the proposed changes well in advance of 6 April, as a great many “salaried partners” will be treated as “employees” for income tax and national insurance contributions purposes.

In Depth


Wide ranging changes to the way in which LLP members are taxed are due to take effect on 6 April 2014. Although final guidance is yet to be published, significant changes to the current proposals are not expected.

LLPs and their members, particularly those in professional service and private equity/fund management firms, should, therefore, consider the impact of the proposed changes well in advance of 6 April, as it is expected that a great many “salaried partners” will be treated as “employees” for income tax and national insurance contributions purposes, with the associated cost and administrative changes that that entails.

What is changing?

At present, LLP members are taxed as employees only if they would be considered to be employees for other purposes, such as employment rights. HMRC believes that, as a result, LLPs are being set up as a means to take advantage of the potentially favourable tax treatment that LLP members enjoy, such as the cash flow advantage of accounting for tax on a self-assessment basis and the national insurance saving to the LLP.

Although initially trailed as an anti-avoidance measure, the new legislation is drafted extremely widely and will, in fact, capture a large number of firms that are set up with no avoidance purpose.

The new regime will deem LLP members to be employees if they satisfy each of the following three conditions:

  • The member performs services for the LLP in his or her capacity as a member and is expected to be “wholly or substantially” remunerated (see below) by way of “disguised salary”.
  • The member does not have a “significant say or influence over the running of the business as a whole, as opposed to individual parts of the business.
  • The member’s capital contribution to the LLP is expected to be less than 25 per cent of the disguised salary that the member will receive in that tax year.

Once all these conditions are met, the LLP will be obliged to operate PAYE and withhold income tax and national insurance at source on payments to the relevant member.

Disguised Salary

What is a Disguised Salary?

The definition of disguised salary captures remuneration that is fixed or, if variable, is not affected by, or varied, to take account of the profit and loss of the partnership as a whole.

The effect of this is striking. Firstly, it would appear to apply to a member who is substantially remunerated according to his or her own performance, such as someone who is paid depending on the performance of his or her own team, desk or book of clients.

Secondly, it will significantly increase the cost of member hires where guaranteed remuneration is offered as an incentive to join and/or as a necessary incidence of the risk of building a business, even where that member is intended to have a major say in, and contribute significantly to, the running of the LLP.

In addition, HMRC draft guidance appears to consider that bonuses linked to an individual’s performance are disguised salary for the purposes of the draft legislation, as they are paid with reference to the individual, rather than to the profits of the business as a whole. This interpretation appears to be at odds with the commercial practice of paying such bonuses, where individual performance is more commonly used as a method of calculating how to divide up the profits of the business as a whole.

In any event, proper documentation (including a properly drafted partnership agreement) and record keeping when calculating any such bonus awards, clearly showing the link to the profits of the business as a whole, should be kept in the event HMRC does decide to litigate on this issue.

What Does “Wholly or Substantially Remunerated” Mean?

Wholly or substantially remunerated is not defined in the draft legislation. HMRC has, however, indicated that the new provisions will apply where an LLP member’s remuneration is at least 80 per cent disguised salary.

Significant Influence Over the Running of The Business

As indicated above, HMRC consider that, in order to avoid being caught by this condition, the LLP member must have a significant influence over the running of the LLP, and not just over a particular area or business stream.

HMRC’s draft guidance states that the significant influence requirement will not be met simply because an LLP member has voting rights, can approve annual accounts or has the ability to participate in the election of a management committee. Rather, the member must have actual influence over the affairs of the LLP as a whole.

The effect of this is that, in larger professional LLPs, the test of significant influence is unlikely to be met for all but a handful of members of senior management. Again, this would appear to exclude LLP members who head up a particular line of business if they do not also exercise significant influence over the LLP as a whole, even if the line of business itself is a fundamentally important part of the business of the LLP.

Capital Contribution Expected to be Less Than 25 per cent of Members’ Disguised Salary For The Year

Finally, it is again likely that all but a handful of LLP members will be able to rely on this condition for exclusion from the new regime.

Broadly, the definition of capital contribution only captures genuine capital held in the business and does not capture, for example, undistributed profits, which will normally be held to serve the same purpose and provide cash flow to the business.

Similarly, it seems likely that loans will only constitute capital for the purposes of legislation if they are of a long term nature. Loans that are made with funds borrowed on a limited recourse basis will not be sufficient; the member must be at actual financial risk.

It is uncommon for professional partnerships to require significant capital contributions from its members. Typically, undistributed profits are used as a different means to achieve the same end.

Other Points to Note

As already noted, if an LLP member satisfies all three of the conditions outlined above, he or she will be deemed to be an employee for income tax purposes. As a result, his or her income will be subject to deductions for tax and national insurance contributions via PAYE.

The member will therefore lose the benefit of paying tax on a self-assessment basis, e.g., a small NICs saving and a cash flow advantage. The true impact, however, will be felt by the LLPs, which will need to account for employer national insurance contributions at a rate of 13.8 per cent on potentially large groups of highly remunerated individuals.

It is also important to note what the new test will not do:

  • LLP members will not be deemed to be employees in a wider legal context, such as employment law, but for income tax and national insurance contributions purposes only.
  • It will not affect members of non-UK LLPs, even if they have UK-based members.

As a result, LLP members face the very real prospect of enjoying the worst of both worlds: being taxed as an employee whilst being denied all the associated employment rights. We also now have the rather odd prospect of members of US and other non-UK LLPs being treated differently to their UK counterparts, although we may well see HMRC try to apply the same principles to non-UK partnerships under the common law.
The new provisions will be introduced with a targeted anti-avoidance provision aimed at preventing abuse of the new system. Mitigation strategies, therefore, will need to be carefully formulated to avoid falling foul of the anti-avoidance rules.

Comment

The wide-ranging proposals look certain to have a significant effect on the way that LLP members are treated for tax purposes after 6 April 2014. The provisions themselves cast a very wide net and capture what most would regard as genuine partners (in the ordinary, partnership law sense) despite being aimed at reducing anti-avoidance.

It is important that all LLPs consider their remuneration structures carefully before 6 April 2014 as the legislation will take effect immediately and PAYE will need to be operated from that date.

Similarly, any business in the process of converting to, or setting up, an LLP should consider the effect of the proposals and take appropriate advice before doing so, as the additional national insurance cost could be substantial if the right remuneration structures or capital calls are not put in place.