Change of status: Manage newly-classified LLP salaried members

In December 2013, the UK
government announced its ‘salaried member’ tax legislation for limited liability partnerships (LLPs) and it has been the talk of the town ever since.

The government proposes that
some members of LLPs will be classed, for tax purposes, as ‘salaried members’ and as if they are employees. This means that firms will be liable for employers’ national insurance contributions
(NIC) on the profit shares of their
salaried members. The legislation does not apply to general partnerships under the Partnerships Act 1890 or overseas LLPs.

The three conditions

As a reminder, the definition of a salaried member is based on three tests. In the context of this legislation, it is failure
that is ‘good’ – a member only needs
to fail one test to avoid being classed
as a salaried member. Pass all three conditions and a member is classed
as a salaried member and will be taxed
as if an employee. The three conditions
are to be tested where a member
provides services for the LLP.

• Condition A - the member’s profit share is wholly or substantially wholly (i.e. at least 80 per cent) ‘disguised salary’.

• Condition B - the individual member does not have significant influence in the running of the LLP.

• Condition C - the individual member’s long-term capital does not exceed 25 per cent of his ‘disguised salary’.

Disguised salary is, broadly, fixed shares and variable rewards which do not vary with the firm’s profits (so, a bonus based on a percentage of personal billings,
for example).

Firms need to test all of their members against Conditions A, B and C as at 6 April 2014. If a member passes all three tests on that date, the firm should apply pay-as-you-earn (PAYE) tax to their
income arising from that date.

In determining disguised salary
for Conditions A and C, firms need
to exercise judgement as to likely outcomes, looking ahead and
considering ‘reasonable expectation’.

HM Revenue & Customs (HMRC) will expect firms to obtain and consider all relevant information as at 6 April 2014. This will include budgets, cashflow forecasts, business plans and projections given to the bank, indications given to partners and so on, as well as an overview of past experience.

Updated guidance

HMRC published initial guidance on the draft legislation in December 2013. It then produced updated guidance on 21 February 2014. This updated guidance extends to 58 pages and contains 62 examples to help LLPs to understand HMRC’s interpretation of the new rules.

In discussing Condition A, much of the guidance covers the treatment of performance rewards. Are they a share of the firm’s variable profits via assessment of performance, or does personal performance lead to a personal bonus unrelated to the firm’s profits?

HMRC also discusses the different treatment of monthly payments on account of a variable profit share compared to monthly payment of a fixed entitlement.

HMRC’s February guidance on Condition B is a lot more helpful than its initial December guidance. It outlines how involvement in discussing and making the strategic decisions of the firm can amount to ‘significant influence’ and that it is feasible for all partners in medium-sized firms of 10 to 20 partners to individually have significant influence, and thus fail Condition B.

However, the guidance does point out how HMRC will watch out for the restricted rights of junior members in the decision-making process. This means that junior members, even in small firms, could be found to pass Condition B and thus potentially be salaried members dependent on how Conditions A and C apply to their situation.

On Condition C, the original draft legislation indicated that, to qualify for
the test, capital would have to have
been paid up as at 6 April 2014. A commitment to subscribe capital subsequently would not count. Facing a rush from firms to restructure their finances before 6 April 2014, it
became clear that banks would struggle to process all of the partner capital loan applications they were receiving.

HMRC’s February guidance
pleasingly indicates that, if a member
has promised by 6 April 2014 to subscribe capital, that capital will count
in the Condition C test as long as it is paid in by 5 July 2014. The government then published updated draft legislation in early March 2014 confirming this relaxation of the rules.

Anti-avoidance catch

However, LLPs still need to watch out for the specific anti-avoidance clause, specifically when organising fresh capital subscriptions from members. The anti-avoidance clause in the draft legislation will take effect from 6 April 2014. It is broadly written and, in essence, allows HMRC to ignore arrangements with one
of the primary purposes of ensuring that one of the salaried member tests is failed. At first sight, this could mean that organising for members to subscribe extra capital to a level above the Condition C threshold might not be taken into account in the capital contribution test.

In the draft guidance, HMRC indicates that a genuine subscription of capital is potentially a game changer to which HMRC would not apply the anti-avoidance clause, dependent on the arrangements surrounding the capital subscription.
The guidance goes on to acknowledge that members will often borrow their capital from a bank. HMRC indicates
that borrowing to subscribe additional capital that expands the firm’s finances should be acceptable.

Unfortunately, HMRC’s further comments on what it regards as artificial arrangements which it may challenge under the anti-avoidance clause go beyond what one might expect. HMRC regards the making of a loan from the firm to a member to enable that member to make a capital contribution to the firms as an artificial arrangement. One might like to argue that this should not necessarily be the case, but it is understandable that HMRC would see such an arrangement as potentially very artificial.

But HMRC then takes the example further. It indicates that its view of artificial arrangements includes situations in which a firm organises for a bank to make a loan to a member out of a partnership facility (as is normally the case) and, as part of the arrangement with the bank, the firm agrees to reduce other indebtedness to the bank. HMRC’s view appears to be that, as the firm’s and the bank’s overall position has not changed, the capital subscription is not genuine.

Where a firm has an overdraft, a fresh injection of capital from members must, on the day of receipt, reduce the firm’s overdraft. To make sense within HMRC’s other comments on genuine capital subscriptions, its anti-avoidance concerns presumably only apply where the firm agrees to reduce its overdraft facility as part of the arrangement of partners’ loans for capital. Firms thus need to take great care in agreeing the terms of any fresh partner capital loans with their banks.

Unsuccessful challenge

The government published its updated salaried member clauses on 7 March 2014, confirming again that the legislation is still due to be effective from 6 April 2014. On 11 March, the House of Lords’ Finance Bill sub-committee announced that it was recommending that the government delay the salaried member legislation by a year so that further consultation could be undertaken
on the proposals.

Despite the concerns raised by the House of Lords, which considered evidence from many professional bodies and individual firms, the government quickly announced that it would not delay the start date of the salaried member proposals, which remains at 6 April 2014.

At this stage, LLPs have no realistic option other than to assume that the legislation will commence on 6 April 2014 and be in the form announced on 7 March 2014. Although the ‘salaried member’ legislation will not receive Royal Assent until July 2014, it is to be effective from 6 April 2014. Firms need to take care to document their position now and to carefully consider the HMRC guidance in areas where there might be some doubt.

Practical implications

?So, what are the practical implications for law firms? If a member is to be treated as a salaried member from 6 April 2014, PAYE and NIC procedures will apply from that date.

Becoming an ‘employee’ for
tax purposes

If a member ceases for tax purposes to
be treated as self employed on 5 April 2014, there are several practical points
for firms to consider.

Any payments or drawings that relate to the period after 6 April 2014 will be liable to PAYE and NIC when paid. For partnerships with a 31 March year end, this should be relatively easy. However, for those with other year ends, it will be necessary to work out how much of each payment relates to duties before or after
6 April 2014.

Once the firm has identified its salaried members, it will need to issue them new-starter forms or ask the relevant questions that would relate to any new employees joining without a PAYE code. This will determine what tax code you need to operate for each salaried member. Initially, the firm will have to operate an emergency tax code until the salaried member has been issued with a PAYE code.

The firm will also need to collect
and account for any primary (employees) Class 1 NICs on behalf of the member and pay over secondary (employers)
Class 1 NICs, currently 13.8 per cent,
on the same amount.

A salaried member will also be subject to benefits-in-kind rules. This means a potential Class 1A liability for the firm.

Actions for salaried members

Individuals who will be classed as salaried members under the new legislation will also need to get up to speed on their changed tax position. They should:

• check that they agree with the decision on their salaried member status and which payments during the transition will be part of their self-employment income and which will be subject to PAYE/NIC via the payroll system;

• check whether the firm has tax reserves to cover all of their
  self-employment income through to cessation; and

• check their tax code. Most members are likely to be given an emergency basic tax code following completion of their new-starter questions; they should ensure that HMRC corrects this quickly. Points to consider:

- if a salaried member has more than one source of income, the PAYE code may be allocated incorrectly;

- if the member has earnings over £100,000, the PAYE code may need to be adjusted for the loss of personal allowance over this amount; and

- if the member has taxable benefits in kind (such as medical insurance or a company car), these should be taken into account in the tax coding.

Salaried member expenses

A salaried member’s expenses will be treated for tax purposes in the same
way as those of any other employee –
as potentially employment income.

In the past, as a self-employed individual, certain expenses may have
been disallowed in the firm’s tax computation or added to the member’s drawings. These expenses will have to
be reported by the firm on a form P11d as a benefit in kind and included on the salaried member’s tax returns, unless the firm has a dispensation for business-related expenses.

The firm may need to check that
the dispensation is up to date and
covers business expenses paid or reimbursed to salaried members
where these are different from those
for other employees.

Pensions and auto-enrolment

If salaried members are making contributions into a current pension scheme, they will need to check if they can continue to do so. If they are not making contributions, when pension auto-enrolment applies, the firm will need to determine if salaried members are eligible jobholders – either as ‘employees’ or ‘workers’. Identifying whether a member qualifies as an employee or worker within an LLP is not straightforward and will depend on the terms under which each individual is working.

If salaried members currently have employment contracts, they will need to change their pension arrangements and should be considered for auto-enrolment when this applies to the firm. However, if they have membership agreements, the firm will have to consider if they are workers. A ‘worker’ is an individual who undertakes to do work under a contract of employment or another contract undertaken to work or perform services personally. This is known as a ‘contract of service’.

Cases covering this point for consideration include Tiffin v Lester Aldridge LLP and Clyde & Co LLP
v Bates von Winklehof.

Louis Baker is head of professional practices and Susan Ball is
partner at UK accountancy firm
Crowe Clark Whitehill
(www.crowehorwath.net/uk)