LLP stakeholders: Financial reward and ownership under the Finance Act 2014
William Wastie explores the options under the Finance Act 2014 for UK law firms looking to change their reward and ownership structures
Over the past six months, much of the emphasis in UK firms operating as limited liability partnerships (LLPs), particularly those with fixed-share partners, has been on looking to ‘fail’ condition C of the new Finance Act 2014 in terms of maintaining the self-employed status of their partners for tax purposes and ensuring those partners have sufficient capital at risk in the business. This has been due to most advisers considering condition C as the surest route to establishing with HMRC agreed self-employed status and hence maintaining the National Insurance Contribution (NIC) levels of both LLPs and their members.
The importance of maintaining this tax neutrality and the unedifying rush by HMRC to have the provisions in place from 6 April 2014 (notwithstanding the complex overplay between partnership, LLP and employment law) has necessarily prevented many from considering the other options available, including looking to fail Condition A – the more than 20 per cent variable profit test.
Finance Act 2014
Changes to the taxation of UK LLP members are outlined in Schedule 13 of the Finance Bill 2014,which became effective for these purposes as of 6 April 2014 and received royal assent on 17 July 2014. HMRC guidance has also been published. The changes affect LLPs in all sectors, including law, accountancy, financial services and real estate.
The changes mean that, where all of the relevant conditions set out below are met, members of LLPs will be taxed as employees. This means that the profit shares payable to such members are now subject to PAYE and Class 1 National Insurance Contributions (NICs). An additional 13.8 per cent of employer NICs needs to be paid by the business as a charge on each member’s income.
Unless one or more of the following three conditions are failed, an LLP member will therefore be determined to be an employee for tax purposes.
A The member performs services for the LLP and it is reasonable to expect that at least 80 per cent of the total amount received in respect of the member’s performance of services is ‘disguised salary’. Disguised salary is defined as remuneration which is fixed, or variable without reference to an LLP’s overall profits, or is not in practice significantly altered by the overall amount of an LLP’s profits. Notwithstanding that a fixed share may abate where there are insufficient profits, the guidance states that, where any repayment is unlikely, then the amounts will qualify as ‘disguised salary’.
B The member does not have significant influence over the LLP’s affairs.
C The member’s capital contribution to the LLP is less than 25 per cent of the member’s ‘disguised salary’ in the relevant tax year.
Existing LLP members are assessed on whether or not they fail one of these conditions as of 6 April 2014. New members are assessed as of the date they become members of the LLP.
Condition A
Condition A has, as its basis, the concept that members of LLPs are sharing in the profits of the business. They are its proprietors and owners, and therefore are exposed to the risks of such ownership as well as the rewards. Therefore, the concept of ‘guaranteed’ earnings or fixed amounts of profit allocation is argued to
be contrary to the risk element inherent
in self-employment.
Whilst Condition C has the attraction of simplicity in being an arithmetical and determinative test which (other than the issue of defining the disguised salary element) provides some certainty, it is not without its difficulties. The financial pressures on many fixed-share partners, as well as what they may perceive as a limited exposure to the benefit of super profits of the business, can make an increased capital exposure an unpalatable option, particularly when not allied to any tangible increased reward.
Furthermore, although the banks have been willing to lend and have done much to assist in helping firms to structure new partner capital loans in time to meet the new legislation, there continues to be pressure on overall lending – not least
on a personal basis.
Notwithstanding the current more confident economic environment, it is frequently at this stage of the cycle that firms come under increased pressure on their margins as investment opportunity costs increase. This, combined with continued pressures on pricing (which are here to stay), together with the limited scope for further reductions in internal costs, means that profit margins are under pressure. This leads to more difficult discussions as to how those profits are to be appropriated between the partners, with relativities becoming more stark and high performers demanding greater differentiation.
The opportunity therefore exists for firms to look now to modify their equity structures and to exchange what has been termed ‘disguised salary’ for true ownership of the business. With a change of government due in 2015 and ever-increasing fiscal pressures, along with an apparent lack of recognition and sympathy for what the professions contribute to UK plc, it would not be surprising if the more formulaic approach of Condition C is revisited by a future Chancellor of the Exchequer in an attempt to increase
firms’ NIC liabilities.
Succession planning
In many firms over the past 20 years, there has been a significant increase in the fixed-share partner class of members. This has been due, in part, to a more benign economic environment, which created an increase in professional instructions that firms wanted to service by ‘partners’ whilst seeking to preserve the actual equity. This led to some being over-promoted and then unable to meet the competitive demands of the great recession. Whilst some firms have encouraged recruiting into a fixed-share level in order to provide a testing ground for lateral hires, there continues to be a legacy of overpopulation of this level which can be self-defeating.
Much is written about the attitudes of younger professionals who have less respect for hierarchical arrangements and who often feel thwarted in their ambitions to contribute and be rewarded. These individuals are the future of the business and, with the competition to hire talent being intense, succession planning has never been more important. The ability therefore to move away from requiring more onerous capital commitments for actual exposure to the profits of the firm through a true ownership stake will be a huge incentive to many fixed-share partners, who often complain (to the obvious delight of the taxman) that they are nothing but glorified employees.
This is not to underestimate the challenges of such a move to the full equity model. Some fixed-share partners will not want the pressures of equity ownership or the exposure to variable profits. Established equity partners will hesitate to agree to what they see as dilution of the equity.
Some firms will not be profitable enough to make the change. If, however, the right people have been recruited and promoted, this should allow a strengthening of the equity with a new generation who are ready to commit further to the business.
One of the most satisfying elements of the move to LLP status was often the desire in many firms to secure such succession planning. Those firms which have the confidence to enfranchise their members in this way, as well as a strategic plan to grow their profitability, will see their currency rise.
Tax alone should never be a sole motivating factor in any structural change but, with the benefit of also securing the appropriate self-employed status for its members, some bravery in opening up ownership may become a potent differentiator.
William Wastie is head of the professional practices group at Addleshaw Goddard (www.addleshawgoddard.com)