Since their birth in 2000, limited liability partnerships (LLPs) have become the preferred vehicle for most professional services firms, including lawyers and accountants. They combine the tax transparency and flexibility of a general partnership with the separate legal personality and limited liability of a company.
The members of the LLP are taxed individually on their share of the LLP’s profits but no tax is paid by the LLP on those profits. It is up to the members to agree how the profits are allocated between them. Often, larger firms have a two-tiered system of membership: equity partners, whose profit share is wholly dependent on the firm’s performance, and fixed share members who receive a fixed share of profits (like a salary) which is not, or perhaps only partially, dependent on the firm’s overall performance.
Self employed status
Historically, all LLP members have been treated as self-employed for tax purposes meaning they are not paid through the PAYE system and the LLP does not have to pay employer’s National Insurance Contributions (NICs) on payments made to them.
HMRC has become concerned that some LLPs are using the self-employed status of all members as a tax avoidance measure, to avoid paying NICs on what is effectively salary paid to employees (whilst at the same time also denying those members the benefit of employment rights).
New proposals announced by HMRC will apply from 6 April 2014 and will create a new category of ‘salaried member’, that is a member of an LLP who is to be treated for tax purposes as an employee rather than as self-employed. Confusingly, the test is different from that for ordinary employment law purposes, meaning an individual could be an employee for tax purposes but not, for example, for the purposes of conferring employment rights on that individual.
An individual will be treated as a salaried member if the following three conditions are all met:
- The individual performs services for the LLP and in return is paid an amount which is wholly, or ‘substantially wholly’, fixed or, if the amount is variable, it is not variable by reference to the overall profits or losses of the LLP. This is known as ‘disguised salary’ and HMRC guidance indicates that the condition will be met where 80% or more of an individual’s remuneration is fixed;
- The individual has no ‘significant influence’ over the affairs of the LLP. HMRC guidance gives examples of what may or may not amount to significant influence for this purpose – having a vote to approve the annual accounts, or a vote to elect members of the firm’s management committee, or even managing a section of the firm’s business, would not constitute significant influence; and
- The individual’s capital contribution to the LLP is less than 25% of his ‘disguised salary’ for the year.
So, if you’re an LLP member with less than 20% of your remuneration based on the whole firm’s performance, whose capital contribution is less than 25% of your annual remuneration and who only votes to approve the annual accounts and elect the management board, HMRC may well view you as a ‘salaried member’ liable to PAYE income tax and NICs.
What should LLPs do?
It seems unlikely that HMRC intended the proposed changes to have quite such wide-ranging implications when they first decided to tackle this issue. But the draft legislation indicates that most professional services firms could be affected. Many of those firms have their year end on 30 April and it’s unfortunate that HMRC is pressing ahead with introducing the reforms on 6 April this year rather than allowing firms to address it in their next financial year.
Whilst HMRC is still consulting on the proposed changes, LLPs should start thinking now about whether they need to change their remuneration structures to ensure that any fixed share members can properly be categorised as self-employed and will not be caught by the new ‘salaried member’ status. The associated NIC cost of that categorisation means this is something which firms simply can’t afford to ignore.
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