Changes to the Employment Status of LLP Members – Why LLPs Should be Examining Their Current Structure as a Matter of Urgency

When is a partner not a genuine self employed partner for tax purposes? One simple answer is when the individual is really an employee. In traditional partnerships a person may be a partner in name only and be deliberately treated as a salaried partner. Alternatively they might be given a fixed share of profit and treated as self employed, but depending on the exact circumstances HMRC might still regard them as an employee. 

The situation is even more complicated within a limited liability partnership or LLP. Under the LLP legislation, the LLP is an incorporated entity, like a company. The owners of the business are members of the LLP but are often referred to as partners. Owing to a quirk in that legislation, an employee might also be a member. Under current tax rules, individual members are treated as if they are partners in a traditional partnership i.e. they are taxed on a self employment basis. 

One answer to this contradiction would be to remove the presumption that all members of an LLP are self-employed for tax purposes. HMRC, in viewing LLPs as a source of potential tax avoidance through “disguised employment”, wishes to introduce a new approach based on the concept of the salaried member. In the original consultation document of May 2013, HMRC set out a test based on two conditions which, if either was met, would mean the individual member would be a salaried member or employee and taxed as an employee. The first condition was a general one in the sense of whether an individual member, but for the device of being called a member, would be regarded as an employee employed by the LLP. The second condition was whether the individual had no economic risk in the event the LLP made a loss or was wound up; or whether the individual was not entitled to a share of the profits or a share of any surplus assets on a winding up.

Following the responses obtained in the consultation exercise, on 10 December 2013 the Government published its summary of the responses and gave further information on what it intended to do. At about the same it published draft legislation for inclusion in the Finance Bill and changes to the National Insurance Contributions Bill to give effect to the new approach. HMRC has dropped the first condition from the consultation document but in effect has expanded upon and revised the second condition so we now have three new conditions which if met means the individual member is a salaried member or employee. Those conditions set out in the Finance Bill are summarised as follows:-

• Condition A: the member is to perform services for the LLP in his or her capacity as a member, and is expected to be wholly or substantially wholly rewarded through a “disguised salary” that is fixed, or if varied, varied without reference to the profits or losses of the LLP;
• Condition B: the member does not have significant influence over the affairs of the LLP; and
• Condition C: the member’s contribution to the LLP is less than 25% of the disguised salary.

There are also further anti-avoidance measures to ensure an individual LLP member does not provide services via a corporate member.

If LLPs are not now planning how to deal with this new approach, they are in for a shock. The changes will be effective as from 6 April 2014. LLPs are therefore being forced to re-examine their current structures. Professional service firms and hedge funds are classic examples of where the junior members may make no capital contribution, have no management or decision-making powers, or have no share of profits beyond perhaps a fixed share or combined with a few bonus share points. The new approach raises some rather fundamental questions as to how and on what basis the junior members should be dealt with. It also raises the question as to their income levels, as any conversion to being employees will involve the LLP paying employer national insurance contributions and may also trigger other entitlements based on an individual becoming an employee. Overall, the costs of the LLP will go up, although those costs will be regarded as an expenditure item. The other possibility is to change current structures so that the junior members do not meet the new conditions, but this may require a radical alteration in the status of the individual member and in many cases would require substantial amounts of money to be paid as a capital contribution for perhaps no extra sharing of the profits.

The consequences of not addressing these issues and subsequently individual members being regarded as salaried members will be the recovery of unpaid taxes, employer and employee national insurance contributions, and the payment of fines and penalties. Matters are further complicated by the manner in which self employment taxes are assessed based on future income.

LLPs and traditional partnerships must also bear in mind the new anti-avoidance rules on mixed members or partners, where an LLP or a partnership uses a corporate vehicle to save tax or to reallocate profits or losses according to the tax positions of the relevant individual and corporate entities. Hedge funds, asset fund managers, and other financial services businesses based on the LLP model using a corporate member or partner are especially vulnerable to these new rules. It may not, depending on the circumstances, be beneficial for a junior member of an LLP (or for that matter a junior partner in a traditional partnership) to remain with that status where a corporate vehicle is used to soak up excess profits to which they have no access, but where HMRC may in calculating tax reallocate such excess profit to the individual members.

LLPs must review the current arrangements for individual members and the relationship between individual and corporate members of the LLP. Some tough decisions will have to be made. Member or salaried member? Individual members must also seek advice on the impact of these changes.