Three-point turn: disguised salary, significant influence and capital contribution

Since the advent of the Limited Liability Partnerships Act in April 2001, LLPs have quickly become a popular structure for law firms, hedge funds and professional practices. Seemingly, they offer the best of both worlds: the fixed liability of a limited company allied with the structural flexibility of a partnership. However, they now face their first major challenge.

LLPs vary in how they are structured, but a common model includes: full equity members, who contribute capital and share profits; and fixed share members, who contribute some capital and receive a fixed share of profits.

LLPs are currently treated as partnerships for tax purposes, but HMRC is concerned that some fixed share members are avoiding employee tax and national insurance contributions despite having a guaranteed income and little say in decision-making.

The new rules contained in the draft Finance Bill 2014, due on 6 April 2014, would remove the presumption that an LLP member is self-employed for tax purposes and replace it with a three-condition test. In the face of widespread outcry over the test and its application, HMRC has issued a revised technical note and guidance.

The guidance clarifies that members of an LLP “who are, in effect, providing services on terms similar to employment are treated as ‘employees’ for tax purposes”. An individual member of an LLP will be treated as an employee if all three conditions are met:

1. Disguised salary

Disguised salary is an amount that is either fixed; variable (but varied without reference to the overall amount of the LLP’s profits or losses); or not, in practice, affected by the overall profits or losses of the LLP.

2. Significant influence

This condition is met if the mutual rights and duties of the members and the LLP do not give the member in question significant influence over the LLP’s affairs. Those who are involved in the management of the business are considered to have significant influence, as are those who have little interest or say in the day-to-day management, but whose roles and rights mean that they can exert significant influence over the business as a whole.

3. Capital contribution

This condition is met if the member’s contribution to the LLP is less than 25 per cent of the disguised salary.

Ramifications

Of this – perhaps unholy – trinity, disguised salary is the easiest to ascertain while significant influence is possibly the hardest. How easy will it be to show that you exercise significant influence in an LLP comprising more than 100 members where you are not on the management board and do not head up a division of the business?

It is the capital contribution that has sent a ripple of fear through not only the ranks of junior members but more pertinently to their management boards faced with a significant increase in the LLP’s tax and national insurance contributions.

HMRC has promised a three-month grace period to enable capital contributions to be made. However, junior members should beware simply accepting a loan from the LLP to meet their capital contribution. The proposed anti-avoidance provisions make it clear that the debt must be that of the individual member. Therefore, if the LLP loans the money back to the individual or bears the costs of the interest of the loan, HMRC may consider the contribution invalid.

Unsurprisingly, LLPs are hurriedly considering the status of their junior members to avoid paying national insurance contributions. While HMRC simply appears to be on a mission to increase the tax yield, this comes as part of a wider period of reflection about the future of LLPs and alternative business structures.

While junior members will have little say about complying with the new rules and cost-conscious clients squeeze their profitability, senior associates may need to think more carefully before accepting an offer of partnership. SJ

Phillip D'Costa is a partner and James Harrison is an associate at Penningtons Manches