Most readers will be aware of HMRC’s consultation process into various aspects of partnership trades, with one of them being the present, and very longstanding (2001) automatic self employment of all LLP members for tax purposes. In the legal sector, more than most others, there has been a gradual increase in both the number of LLPs, and the number of members in those LLPs. Since the present economic difficulties commenced in 2008, law firms have appointed thousands (literally) of what have to date been called ‘fixed share members’ (FSMs), and HMRC have, until recently, stood back and watched their collection of national insurance contributions, and sometimes income tax, dwindle as a result. HMRC’s consultation, which we are involved in, runs from 20 May to 9 August 2013, and it is anticipated that any new draft legislation will follow in December this year, ready for application from 6 April 2014. There is no mention of anything having retrospective application. At the moment, no-one has certainty as to what is to come. However, you all want and need to know what to do next, so here we will try to set out in a straightforward way where we believe it will end up. Please do read this in conjunction with Section 2 of HMRC’s Consultation Document – please click here. To set the scene, the very strong likelihood is that HMRC will introduce tests into tax law along the lines of the various ‘badges of self employment’ that are very well established in case law for non-LLP members. There are many of these (click here to see a full list and to access the Revenue’s Employment Status Indicator tool), but the main ones are the ability for the individual to: - make both a variable profit depending on performance
- make a loss, on the same basis
- have an element of investment risk
- share in assets on a winding up
- ‘look’ self employed to others
Let us take the case of a typical FSM in a law firm, Lee Gall. Lee’s arrangements are presently: - No capital invested
- Fixed profit share of £75,000
- ‘Bonus’ arrangement of up to £5,000 depending on personal performance
- No risk of financial loss
- Lee has a FSM Deed separate from the main LLP Deed
- Lee’s drawings are paid out net of tax, with the firm retaining the tax money and using it to pay Lee’s self employed tax and national insurance when it falls due
As a result of this, it would be something of a surprise if Lee was able to remain self employed post 5 April 2014. So what can be done? 1. Stop using the term FSM. All members are merely to be called ‘partners’ in future; 2. Stop having separate Agreements for people like Lee, and incorporate all members into the main LLP Agreement; 3. Seek Lee’s agreement for part of his existing tax reserve money to be reclassified as equity capital in the practice. Lee ought not to mind this, as his tax reserve should perpetually be a positive number anyway, given that self employed tax is paid considerably in arrears. Had the practice not retained cash to pay Lee’s tax bills, i.e. Lee was paid gross of tax every month, then asking Lee to contribute some equity capital would definitely be sensible. There are no hard and fast rules about a suitable amount, and it would need to be considered on a case by case basis; 4. Divide the firm’s capital into points, so that Lee has, for example, 20 points out of a total for the firm of 400 or whatever; 5. As a result of 3 above, Lee will be eligible to share in a rateable part of the firm’s capital on a sale or winding up. The amount can always be subject to an upper cap in a third party sale situation; 6. Re-negotiate Lee’s profit share with him. This is likely to be the first one on the list where there may be difficulty. It would seem likely that the variable part of Lee’s overall profit share will need to amount to more than about 5% of the total profit share, but in our example it is at present anyway. Clearly if there is presently no variable element at all, it may be more difficult to achieve; 7. Remove all references to words like ‘bonus’, and replace them with ‘profit share’; 8. Agree with Lee that he will have at least some exposure to potential capital financial loss. Of course, he has some already by virtue of his tax reserve being retained in the firm, and the reclassification of part of this into equity capital does nothing to alter that; 9. As well as 8, Lee will need to shoulder a portion of any future income losses. This sounds a difficult point to negotiate with Lee on, but if you sit back and think about it, it is really quite a feat for an LLP to make a trading loss at all, as losses are measured before deducting LLP members’ drawings, including people like Lee. Therefore, the more FSMs you have in your firm at present, the harder it is to make a loss. If you are able to make Lee understand this concept, hopefully he will be more relaxed about it; 10. Think about all of the peripheral points in Lee’s present FSM Agreement, and make amendments where they are simple to do. For example: - Ensure that Lee’s profit share does not automatically increase in line with any blanket increases to salaried staff;
- Include clauses saying that whatever level of partner you are, you are always invited to put forward a case for further equity;
- Make sure that people like Lee have some say in the way that the practice is run. This may not need to extend to full voting rights;
- Consider whether Lee receives any benefits that staff receive, but equity partners do not. If he does, look to change this if practicable;
- Bring Lee’s peripheral entitlements to things like holiday, sick pay and notice period into line with those of the present equity partners.
What we have said above makes things look pretty simple, and it is of course accepted that this may not be the case in reality. However, our point was to illustrate that it is not necessarily going to be as difficult as you might think either. It seems clear that changes you make need to be both deliberate, and real. HMRC are pretty likely to take a pretty dim view of ‘sham’ type arrangements after 5 April next. To this end, a specific anti-avoidance measure is to be included in the legislation to ‘look through’ arrangements that have been put in place purely to circumvent the new tests. Therefore, quick fixes are unlikely to be what is needed here, and access to advice from someone with experience of both the existing self employed tests and case law, and also partnership agreements and what other firms are doing will be invaluable. We are very well placed to provide this to you.
The views and opinions expressed in this article are those of the authors and are not necessarily those of Hazlewoods LLP. We strongly recommend you take professional advice before making decisions on matters discussed here. No responsibility for any loss to any person acting as a result of this article can be accepted by us.
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