LLPs – time for action to avoid tax issues
- John Deane
- Updated: Mon, 5th Dec 2016
HMRC can now tax LLP members as employees, subject to PAYE. Note, partnerships and LLPs are tax efficient but now less so than before. They are flexible, limit liability and are great for succession planning. They also offer tax planning opportunities for genuine partners.
However, the tax landscape has changed. Tax legislation now seeks to limit the tax advantages for partnerships and limited liability partnerships – LLPs – operated with limited companies and salaried members. In some cases, limited company and salaried members will be taxed as if they were employees on all drawings and the partnership is required to operate PAYE.
Set out below is the background to the taxation. We also touch on ideas for action required by limited liability partnerships – LLPs – if they wish to preserve the self-employed status of its members. Similar rules apply for partnerships but we focus on limited liability partnerships, as LLPs are most likely to be the centre of HMRC focus.
HMRC objections to LLPs
LLPs (limited liability partnerships) have been around for many years and for the right type of business offer advantages. The best use of an LLP tends to be in connection with professional service based businesses where the intellectual property is the people rather than its products. LLPs are widespread in businesses where the “exit” is selling to other members rather than a trade sale.
To exploit the tax planning opportunities LLPs used to offer artificial schemes such as members providing services via limited companies. HMRC saw that as abuse not least because it felt it was losing out on employer’s national insurance contributions which it would have received if the member was employed. The use of service companies to pay out what was effectively a member’s dividend at a lower effective tax rate was also an area of lost tax for HMRC.
Salaried members are taxed like employees
LLPs have to operate PAYE on drawings paid to a member who satisfies three tests: disguised salary, significant influence and capital contribution.
Disguised salary means that 80% of the member’s drawings are either fixed, variable but varied without reference to the overall profitability of the LLP or not in practice affected by the overall profitability of the LLP. If the salary depends on the performance of the partner or performance of a business division HMRC will consider the salary as fixed as it does not vary by reference to the partnership overall.
Significant influence means that the individual member’s rights and duties do not give the member significant influence over the LLP’s affairs. Where a partner has influence over a business division, e.g. Head of Tax, that won’t be enough because the influence needs to be over the business overall.
Capital contribution means the member’s capital contribution to the LLP is less than 25% of the disguised salary that is reasonably expected to be payable to him for his services for the tax year.
The question of whether a member is an employee arises not only on the tax front but also from an employment law perspective.
LLPs have always been at risk that members claim they are employees to benefit from mainly unfair dismissal protection and equal pay rights. Decisions are always based on the facts and involve a review of true management functions and responsibilities. The outcome is never entirely predictable as a “manager” can range from someone in charge of paper clips to running the business’s accounts and signing off for the auditor.
The salaried member regime
The salaried member regime for LLPs forces LLPs to reconsider the employment and tax status of partners every year. When profits increase, a partner’s tax status can change half way. For many LLPs and partnerships the legislation forces greater operating costs via the payment of employer’s national insurance and greater employment law risk if members convert to employed status.
What should an LLP be doing?
The members of the LLP should review their LLP agreement and arrangements for members’ pay. The top five actions to consider are:
1. Suitable LLP agreement
Make sure you have an LLP agreement suitable for your business and that all members have signed up. Examine the role of corporate members of the LLP carefully. It is wise to flag up to the members that they should take advice if they are unclear of their position as their tax treatment will have likely changed.
2. Document responsibilities
Review the actual management responsibilities and clearly document ownership of responsibilities. Retain minutes of members’ meetings where such duties are discussed and agreed.
3. Tax indemnity
Include a tax indemnity in the LLP agreement so that the LLP can deduct the income tax and national insurance operated under PAYE for any member who satisfies the test from that member’s drawings. Tax retention accounts can be helpful.
4 Partners’ risks
Consider risk and reward. In broadest terms partners take risk as they are in business whereas most employees do not. The practice which has grown up of paying fixed profit shares which are not related to the profits and losses of the business now has to be reviewed. This is an area where LLPs could be vulnerable to HMRC attack. This is also the area where LLPs will meet resistance from partners who will be reluctant to pin earnings to profits in businesses which are not doing terribly well. Introducing fundamental changes need to be planned and managed and often require an overhaul of strategy. We can provide an objective view that can help clear this hurdle.
5 Regular review
LLPs need to keep the position under regular review because if the LLP fails to operate PAYE in cases where it is due there are very onerous penalty and interest payments due to HMRC. In addition the income tax and national insurance should be collected. The members of the LLP who suffer reduced drawings as a result of the tax payments will not be happy.
Similar rules apply for partnerships.
Personal service companies
Another area of scrutiny from HMRC is the use of personal service companies. HMRC looks to tax what they consider is really the payment of salary and to recover resultant unpaid income tax, national insurance contributions and what is often most painful: interest and penalties. Most at risk are those personal service companies where the main item of income is from one business. Genuine personal service companies where the directors can demonstrate that the company is in business seeking revenue from multiple streams as do regular trading businesses will be more difficult for HMRC to attack.
John Deane heads the partnership and LLP team at Gannons. Please do speak to us if you have any queries. We offer you the experience across the disciplines that come into play – usually partnership law, tax law, employment law and commercial and practical knowledge.
I run the London commercial law team and regularly advises partnerships and LLPs on how to trade effectively. The team advises a range of LLPs including professional practices and practices in the financial services sector. The expertise offered includes taxation of LLPs, employment law issues, valuations of LLPs and dispute resolution.