Has partners' tax status been turned upside down in the Budget?

IN HIS SPRING 2013 Budget, the chancellor of the Exchequer announced consultation on legislation to counter the use of LLPs to disguise employment relationships, and the artificial allocation of profit/loss to secure tax advantages, with legislation to be introduced in Finance Bill 2014. The outcome of this consultation will have significant implications for professional services firms operating as partnerships or LLPs.

Removal of Presumption of Self Employed Status

To date, the tax position of members of LLPs (popularly called partners) has been straightforward: if you are a member of an LLP, then you are self-employed and taxed as such.

This tax treatment has made it attractive for LLPs to give the status of member to individuals who, to all intents and purposes, are employees. The consequential removal of the LLP’s obligation to pay employer’s NI contributions (at 13.8% of earnings above the secondary threshold) produces a significant tax saving, particularly in professional and financial services firms, where employees tend to be highly-paid.

This issue has been one of the driving forces behind the abandonment of salaried partner status (i.e. employees who are taxed as such, but who have the title of partner) in favour of fixed share partners, who are members of an LLP entitled to a fixed share of profits which is very much like a salary.

Although fixed share partners can blur the line between senior employee and partner, some LLPs, particularly in the financial services sector, have admitted as members relatively junior employees simply to reduce the LLP’s tax bill, and to prevent those individuals from enjoying full employment rights.

It should be straightforward to identify the ‘equity’ partners in an LLP, who should retain self-employed status. It should also be relatively easy to identify those individuals who are in fact employees and who have been made members of an LLP only to save tax. The middle ground of the fixed share partner is more problematic. It is not clear what characteristics fixed share members will need to have in order to ensure that they continue to be treated as self-employed for tax purposes.

The issue is made yet more complicated by the interaction with employment law. A number of members of LLPs have claimed in the courts and employment tribunals that they are in fact employees with employment rights, including the right not to be unfairly dismissed. In assessing whether a person is a true partner, the court has regard to a wide range of rights including the individual’s capital invested, right to attend partners’ meetings and vote, rights to any residue on a winding up, whether his profit share has a variable element related to the firm’s fortunes, and so on. Each case is decided on its facts, which can vary greatly.

The courts have generally held that a typical fixed share member arrangement is sufficient for the individual not to qualify as an employee for employment law purposes. However, the test that an employment tribunal will use to determine whether a person is an employee or self-employed may be different to the test that HMRC will use to determine whether he will be taxed as an employee. Logically, the tax status of an individual will follow his legal status, but it remains to be seen whether that will satisfy HMRC in the light of perceived abuse.

In the meantime, LLPs that draw a sharp distinction between the rights enjoyed by equity and fixed share partners would be well advised to reconsider the balance of those rights, to reduce any grounds for challenge.

Profit and Loss Allocations

The second matter to be consulted upon is the manipulation of profit and loss allocations by LLPs (and other kinds of partnerships) to secure tax advantages. The Budget offered few clues as to the perceived abuse to which this is directed.

One explanation is that the government wishes further to tighten the rules on the use of partnerships to generate sideways loss reliefs. However, such schemes have already been the subject of legislation (not least the general anti-avoidance rule).

A concern is that the government may instead be seeking to attack the use of corporate members, which has increased in recent years. Corporate members in theory provide a useful means for LLPs to warehouse profits at a low tax rate, particularly where those profits need to be reinvested in the business.

In practice, the state of the economy has militated against their aggressive use in professional service firms which historically have distributed profits in full to members. Corporate members are used for a range of non-tax related structuring and commercial purposes. Any restrictions imposed on their use should recognise this.

Tina Williams is head, and Daniel Sutherland is senior associate, of the professional practices group at Fox Williams LLP