LLPs and tax: When is a member not a member?

by Daniel Sutherland, Fox Williams

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24 Dec 2013

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THERE WAS A collective sharp intake of breath last week as members of LLPs across the country learned of the details of HMRC's proposed approach for tackling ‘disguised employment', which, it had perceived, a number of LLPs were guilty of.

The legislation now proposed to deal with this issue looks set to give rise to a fundamental change in how many professionals and other users of LLPs are taxed. The scale of these changes is far greater than was anticipated, with HMRC expecting the new rules to bring in significant extra tax revenues: £1bn for 2015-2016 alone.

The problem with which HMRC was seeking to deal was fairly straightforward - a few LLPs were dressing up junior employees as members in order to take advantage of HMRC's presumption of self-employment for LLP members and benefiting from substantial National Insurance savings as a result. However, the abuses of an unscrupulous few have brought misery to the honest many, as HMRC's solution is the proverbial hammer to crack the nut. And a hammer that seems in some ways to miss its target.

Indecent proposal

The core of HMRC's proposal is that members of LLPs will be taxed as though they were employees if they satisfy all of the following three conditions, namely:

A - at least 80% of the individual's reward is a "disguised salary", i.e. a sum that is fixed or, if variable, is varied without reference to overall profits of the LLP or not, in practice, significantly affected by overall profits;
B - the member does not have significant influence over the affairs of the LLP; and
C - the member's contribution to the LLP is less than 25% of the disguised salary.

At first glance it may seem simple to get a member over one or more of these hurdles, but ensuring that every member of an LLP avoids being caught by the new rules may not be feasible for many LLPs without substantive changes to their business model. Anti-avoidance rules may also prevent changes designed to deal with the new tax regime.

The problems the new law will create for LLPs will go far beyond the question of the status of ‘fixed share' members. For example, in a large LLP it may well be the case that senior members are rewarded based in the performance of their practice area rather than the LLP as a whole.

This, oddly, may be considered as ‘disguised salary', due it not being linked to the profitability of the LLP as a whole. It is also likely that in a large LLP very few members will have significant influence over the affairs of that LLP, with decisions typically being delegated to a management board.

Also, if the LLP has low capital requirements, or is funded by means other than partner capital, a 25% capital contribution may simply be inappropriate for the business. In such circumstances the new rules would potentially cause even very senior members, in respect of whom it is perfectly clear they are not the disguised employees which HMRC was purportedly seeking to deal with, to be taxed as employees.

In choosing the criteria to apply, HMRC rejected the option of applying existing legal tests used by courts and employment tribunals to determine whether a member is truly a member or is, in reality, an employee. The legal tests adopted by the courts look at a range of factors and seek to establish the truth of the relationship between an individual and an LLP, rather than using limited and arbitrary criteria. The existing legal test has not gone away, so firms may, somewhat bizarrely, find that its members are taxed as employees but have no employment rights and vice versa.

The criteria chosen by HMRC have the benefit of offering firms greater certainty than the existing legal tests, but they are clearly inadequate criteria if the purpose is to properly distinguish between employees and partners.

It is fairly common for employees to invest significant sums in their employer, to be paid according to their employer's profits and to have a senior management role, so those factors cannot be those which get to the root of the relationship.

Similarly, just because an employee contributes 25% of his remuneration as a ‘capital contribution' seems insufficient proof that such an individual is truly a member and not a disguised employee.

Problem unsolved

Given these issues, it is hard to conclude that HMRC has fully dealt with the problems presented by disguised employees or in identifying ‘true' members.

As the changes bed in, LLP members may look jealously upon their brethren who have the good fortune to operate through overseas LLPs or traditional partnerships, both of which have escaped in this round of changes. Whether than jealousy translates into firms moving to different business vehicles remains to be seen. What is certain, is that the question of what is truly means to be a member has become even more complicated.

Daniel Sutherland is a senior associate in the professional practices group of Fox Williams LLP

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