Status and obligations of partners
- John Deane
- Updated: Wed, 7th Dec 2016
A partner’s status and obligations in a partnership impacts many rights and liabilities for both the partnership and its partners. Within any partnership the status of partners determines the flow of rights and restrictions. You need to know where you stand because the rights differ under different types of partnership.
Our partnership services include:
Significance of status
Establishing whether a member is likely to be regarded as an employee or a genuine member of the partnership is important for a number of reasons. Generally speaking, the restrictions and duties imposed on a member are greater than in respect of an employee. Partners have fiduciary duties to one another.
In practice the status and distinction between members of a partnership and non-members or employees will lay dormant. Nobody cares until something happens which causes the parties to pay attention. The typical issues encountered in partnerships and LLPs where status plays a role include:
- Handling member departures from a partnership – voluntary and involuntary. This includes how to deal with capital payments on the departure of a member.
- Enforceability of post termination restrictions and covenants for partners. This often arises if a departing member sets up in competition and/or takes clients.
- Dealing with claims for employed status brought by partners against the partnership. This often arises if a departing member has been sacked or turned over for promotion in circumstances they consider to be unfair.
- Taxation of members’ drawings. The question is can they be treated as self-employed in the eyes of HMRC?
Who is a partner?
There is no statutory definition of partner, or member of a common law partnership, or LLP. The mere sharing of profits with others is not regarded as conclusive evidence that a salaried member is a genuine member but taken together with other relevant circumstances, it could lead to that conclusion. Other factors will be at play.
Can a partner be an employee?
It is necessary to scratch below the surface and understand the relationship between the person and the partnership or LLP. The fact that someone is held out as a member does not necessarily mean that they are treated as members for all purposes. A partner can have more than one status with different implications flowing:
- Status for employment law purposes;
- Status for tax purposes; and
- Status within the partnership for commercial purposes.
The name given does not in itself determine status
A whole range of factors needs to be taken into account to determine status for employment law purposes.
Factors to consider include:
- Whether the individual receives a fixed remuneration payable irrespective of the partnership profitability and whether they have a share of the profits and losses of the firm.
- Whether they receive an express or implied indemnity against debts and liabilities of the partnership from other members, or merely a contribution towards those owed to third parties.
- Whether they are required to make a capital contribution, or are entitled to share in the partnership’s surplus assets.
- The level and extent of the right to participate in management decisions, management meetings and partnership votes.
- Whether the individuals name appears on all partnership documentation, they have the right to hire and dismiss partnership employees and whether they have banking authority.
- Whether they are “carrying on a business” with a view to profit.
Control over members of a partnership or LLP
The issue of control has for a long time been regarded as an important consideration when considering the obligations. The greater the power to command and control the partnership (such as through the partnership vote and participation in management), the more likely that an individual will be regarded as a partner. Conversely, the less that an individual has power and rights, the more likely they are to be an employee.
Indictors of employment status
The following pointers do suggest the partner is an employee:
- The individual agrees that, in consideration for a wage or other remuneration, they will provide services for the partnership.
- The individual agrees, expressly or impliedly, that in the performance of that service they will be subject to the control of the partnership and its partners.
- The other provisions of the contract are consistent with it being akin to an employment relationship.
Protecting partnership property
The status of the partner comes into play when considering the enforceability of a restrictive covenant. A typical restrictive covenant found in a partnership agreement or an LLP agreement will deal with:
- Working for a competitor within a specified geographical area.
- Soliciting or canvassing clients, customers, or suppliers.
- Soliciting or employing other partners and staff.
- There may also be restrictions which seek to prevent team moves by stating that for a specified period following departure a member cannot join a firm to which another member from the original firm has recently transferred. Such provisions have not yet been tested in the courts, but are used to prevent multiple departures, predominantly relied on by professional service firms where the clients are the business.
If the partnership agreement has set out the restrictions and the member has agreed to be bound by them there is less room for doubt.
Silence in the partnership agreement
The main difficulties arise when nothing has been documented. Surprisingly often the case. Where the partnership agreement is silent the starting point for construing all post-termination restrictions and covenants, whether against members or employees, is that they are void on the grounds of public policy unless they are:
- Reasonable in the interests of the parties.
- Reasonable in the interests of the public.
- Necessary to protect a legitimate business interest such as trade secrets or business connections.
- Go no further than is reasonably necessary between the parties to protect that interest.
Restrictive covenants in employment contracts are often open to challenge because of the inherent inequality between the bargaining position of the employee and employer. The position of partners is different. The courts consider that there is no imbalance in bargaining power between members of a partnership or an LLP.
No implied term
Where there is no written agreement it is unlikely that any restrictive covenant exists and there is no fiduciary relationship between the partner and the partnership or the member and the LLP once one leaves.
Garden leave under a partnership agreement or an LLP agreement
A garden leave clause in a partnership agreement may suspend the right of departing members during their notice periods. Garden leave clauses typically restrict matters such as attending the office, undertaking client work, participating in marketing activities, attending partners’ meetings, retaining senior management functions and speaking to clients and staff about their departure.
No implied term
In the absence of an express right to do so, the general view is that it is not possible to place a partner on garden leave as, either directly or indirectly, their profit share will be affected by his ability to work.
While members do not qualify for employment protection rights they have the same right as employees to be protected against unlawful discrimination on grounds of:
- Sex, marital status, civil partnership, gender reassignment and pregnancy or maternity.
- Sexual orientation.
- Religion and belief.
Compulsory retirement is not always discriminatory. The position is clearer if there is a written partnership or LLP agreement setting out the terms.
Taxation and the status of members
Unrelated in law to the rights of LLP members as workers or employees is the question of how will they be taxed – i.e. are they treated as self employed or taxed as employees?
Tax rates are lower for the self employed. But, HMRC have clamped down on abuse.
Anti avoidance legislation
HMRC has laid down strict conditions to be satisfied in order to be treated as self employed for tax purposes. To be treated as self employed a partner of any partnership must satisfy one of the following three factors.
1. Disguised salary
Disguised salary means that the at least 80% of member’s drawings are either fixed or variable but varied without reference to the overall profitability or loss of the partnership. 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. It is the sharing of losses which we often find causes problems.
Significant influence means that the member’s rights and duties do not give the member significant influence over the partnership affairs. If a partner has influence over one part of the business, e.g. Head of Finance, that is not enough. Most partners of larger professional firms do not meet this criterion.
3. Capital contribution
Capital contribution means that the member’s capital contribution to the partnership 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 capital contribution position needs to be reconsidered by the partnership each year. This is because as the profits go up the profit entitlement of the partner might be larger than four times his capital contribution making him a salaried member during the tax year. HMRC will use anti-tax avoidance legislation to tax artificial and short-lived increases in partners’ capital contributions used to avoid tax.
If a member cannot point to one of the above three factors and say this does not apply to me – then the member will be treated as employed for tax purposes. Of importance is that the tax legislation only requires the satisfaction of one out of three factors.
Mixed partnerships LLP
LLP’s can comprise of individuals alone or a combination of individuals, companies and trusts. A mixed partnership is where members of the LLP include companies and trusts.
Mixed partnerships became popular as a means of money boxing. Trading income from a LLP is taxed at the highest rates of income tax irrespectively of whether the money is taken out by the member. Whereas, a company only pays the much lower corporation tax and further tax is only paid when a dividend is taken. The idea was limited companies were used for storing reserves not needed for distribution.
HMRC considers mixed partnerships to be abusive in a number of cases which includes:
- Where it is reasonable to suppose that the limited company’s profit share includes what is effectively a deferred profit of the individual and as a consequence of that the individual’s profit is reduced; or
- The limited company is receiving a commercial return for services provided to the LLP which is in excess of what is commercial.
Assessment to income tax and NI
It is reasonable to suppose that the overall tax bill of both the limited company and the individual member is lower than it would have otherwise been, absent the structure. The anti-avoidance legislation attaching to mixed partnerships enables HMRC to assess the member of the LLP to income tax and national insurance on the limited company’s profit share.
Restriction on losses
Where the LLP makes a loss the tax legislation prohibits allocation of losses exclusively to the individual partner of a mixed partnership. If LLP trading losses are allocated purely to an individual partner, neither the individual nor the LLP will be able to relief that loss.
Still of benefit
Despite the tax rules mixed partnerships remain advantageous for succession planning reasons. For example, a partner of a professional firm trading via a Ltd company OldCo Ltd wants to retire. He incorporates an LLP whose partners are he, OldCo Ltd and key staff. The business of OldCo Ltd is then transferred to the LLP. His partnership share is then easily transferred to other members who run the business. OldCo Ltd is then dissolved.
Partnership law and practice is a specialist area of our expertise. We have considerable experience. Do call or email me to arrange an informal discussion. Our team knows how to handle difficult and sensitive situations tactfully and smoothly.