Re-arranging the furniture
Andy Poole and Graham Poles discuss the strategic and tax benefits to restructuring your law firm
Whether you're starting a law firm or have been in business for some time, ensuring you are trading through the right business structure is vital for efficiency, commercial, tax, and strategic purposes.
For many businesses, a transition between structures is an evolution rather than driven by the needs of the firm, and different structures have different tax effects.
The main structures to be considered are:
Trading as a sole trader;
Limited liability partnership (LLP); or
There are also hybrid structures that have a corporate member within a partnership or
LLP, structures which have undergone some changes recently.
The most straightforward structure is practising as a sole trader. In this case, the individual is subject to income tax and national insurance on their taxable profits. Individuals have a personal allowance for the current tax year of £11,000 and any taxable profits above this level will then be taxed at the rates displayed in Figure 1. There is also the small amount of class 2 national insurance, which currently costs the business £2.80 per week but, from April 2018,
will be abolished. As a sole trader, you are taxed on your income as it is earned and so your capital account comprises taxed income and can be drawn without any further taxation consideration.
Turning to partnerships and LLPs, the tax considerations are exactly the same as in Figure 1 because both structures are transparent for
tax purposes. HMRC will not seek to challenge profit shares where those shares are received by individual taxpayers; however, since April 2014, the situation has changed for what is termed 'mixed partnerships'. Mixed partnerships are generally a hybrid containing corporate entities or trusts as partners. The corporate would tend
to be owned by the partners, the idea being to benefit from the lower rates of corporation tax.
The new rules contained in the Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005), sections 850C to 850E, look at the allocation of profits where a corporate entity
is a partner or member and one of two conditions are met. These two conditions look at either
a deferred profit (such as a deferred bonus)
or the profit share received by the corporate to determine if it is an appropriate share and that this share is available to the partner to enjoy and the overall tax is lower than it would have been. The determination of an appropriate profit share is difficult to judge, and the guidance from HMRC, while helpful, does not, in our opinion, use commercially acceptable figures.
These changes have meant the tax savings previously enjoyed by such structures have been reduced and, as a result, we are not witnessing new moves to this type of structure.
A further change introduced at the same time was the introduction of the salaried member rules for LLPs. This change looks at the substance of a member's relationship with the LLP and tests this to see if the individual is self-employed or should be treated as an employee. If deemed to be an employee, they will be added to the payroll of the firm and suffer P11D charge on the provision of any cars or other benefits.
The final structure that a firm may choose is a company. Since it is a separate legal entity, the company suffers its own tax liability, currently paying corporation tax at 20 per cent, but this is set to fall to 17 per cent from April 2020. The lower and reducing rates of corporation tax make a company a very attractive option from a tax perspective, even though there is a further tax charge when the shareholder extracts any funds from the company.
In general terms, there are two main ways of extracting the funds from a company - namely salary and dividend. Income tax is payable on salary at the rates shown in the sole trader section in Figure 1, but national insurance is different, with class 1 employees and employers being payable on any salary greater than £8,060 at
12 per cent and 13.8 per cent, respectively.
The new dividend tax regime started on 6 April 2016 and means that all dividends received above £5,000 will be subject to an additional 7.5 per cent tax charge, giving new dividend rates of 7.5 per cent, 32.5 per cent, and 38.1 per cent. While this increase does make dividends more expensive, there is still a tax advantage in declaring a dividend when compared to taking a salary.
As an example, if a company is making £90,000 in profits with two shareholders who draw a salary to utilise their personal allowances and the balance of profits as dividends they would be taxed as in Figure 2, below: The increase in the tax liability caused by the change in dividend rates for this small company would be £3,266.
The more interesting question really comes as businesses transition between the different structures and deal with the tax consequences of the change. As businesses grow, they may move from sole trader to partnerships or LLPs with very little tax consequence as these structures are tax transparent. They will need to consider any capital gains tax (CGT) implications when the members of the partnership change, particularly if assets have been revalued.
Stamp duty land tax (SDLT) will also need to be considered where there are any property transfers on such transitions, although an exemption may be available.
It is the transfer of a business to a company that has the largest taxation impacts. There will be a chargeable gain if any assets subject to CGT are transferred. Recent tax changes to entrepreneurs' relief, coupled with the dividend changes, had reduced the appeal of incorporations, but the
2016 Budget has brought some much needed
The rate of CGT has been reduced on all gains (other than residential properties), so it is now possible to sell goodwill to a company on incorporation and pay 20 per cent tax. The value of the goodwill could create a healthy director's loan to be drawn against with no further tax to pay. This represents a 12.5 per cent saving on the value of goodwill when compared to the higher rate of 32.5 per cent that would have been charged on dividends.
Land and property are other obvious chargeable assets that may be transferred to a company. In these cases the capital gain can be held over, either by holding over into the asset itself, so its base cost is effectively the same as before the transfer, or by holding over into the value of the shares, so the gain is only payable when the shareholder sells their shares.
If we consider a partnership of individuals
A, B, and C, who collectively make profits of £500,000, we can see from Figure 3 above that incorporation could generate them a tax saving
of just over £122,000 over the first four years.
The calculations are detailed in Figure 3 and the following assumptions are made:
Each partner takes an equal share of the profits and a salary of £8,060;
The business transfers goodwill valued at £300,000 and the partners use that to draw tax-free income from their director's loan accounts in the first year. CGT of £53,340 will
be paid and is accounted for in the calculations (assuming each partners' annual exemption is available); and
Dividends are taken up to £5,000 in the first year, with the balance of drawings up to £100,000 from loan accounts until these are exhausted. In the following years, the drawings of £100,000 each are achieved by a small salary and the balance in dividends.
The tax payable by the individual partners would be as in Figure 3. When the firm converts to a company, the tax position of the company and A, B, and C will change to the following, assuming that after year one they have fully used their directors' loan account, so they then draw a greater dividend
from year two, as in Figure 4. The benefit will vary according to profit levels and individual circumstances. Consideration should also be given to the potential CGT charge on liquidation of the company or on retirement.
Flexibility versus tax efficiency
Figure 5 summarises the taxation
consequences of the available business structures.
From a commercial perspective, while corporate structures tend to be more tax efficient, the price to pay can be the reduced flexibility when compared to partnerships or LLPs.
In partnerships and LLPs, it is easy to manage changes in partners or profit-sharing ratios. With companies, it is slightly more difficult. Remuneration tends to be driven by shareholding and therefore amending profit shares can be a little more complex. Agreements are also required on how to deal with changes in owners, and the following questions should be asked:
Are new shares issued?
What is paid for the shares?
Who acquires the shares of exiting owners?
What price is paid for those shares?
It is possible to retain the flexibility of partnership in a corporate structure, but thought needs to be applied in advance and resolution needs to be clearly documented in a shareholders' agreement, including detailed valuation mechanisms. Issues have been caused by firms incorporating and then only looking at how to deal with these points when there is a change in ownership a number of years down the line. Shoehorning a partnership set up into a corporate vehicle is possible, but not easy, and requires a lot of time and cost investment at the start of any structural review process.
Other factors to review include: limitation of liability; succession planning; ease of conversion; cost; public disclosure; public image; and management of the business. Professional advice is vital if you decide that your business has outgrown its current structure because there are many considerations that need to be taken into account.