Tax changes to partnerships, Menzies comments
22 Aug, 2013
Tax changes could leave professional firms with an unexpected tax bill
– by Richard Godmon (pictured), tax partner at Menzies LLP
In the past many professional services firms, particularly accountants, lawyers, architects and surveyors, made the choice to operate as LLPs, companies or partnerships, or a combination of all three to help manage their tax liabilities. But changes proposed by the government could leave some firms with an unexpected tax bill.
Re-classing fixed profit share partners as employees
Because equity partners are not salaried employees, one of the main benefits of a partnership structure or operating as an LLP is that the partnership does not pay employers’ National Insurance contributions. Strictly speaking LLPs have members, not partners, but currently HMRC treats all members as self-employed. So as with traditional partnerships, LLPs do not operate PAYE and pay no employers NI for their “partners”.
However, HMRC now believes that some fixed profit share partners should be considered employees and therefore be taxed on a PAYE basis with the firm paying employer’s NI.
The consultation period for the proposed changed closed on 9 August and legislation is expected to be drafted at the end of the year. The final legislation will come into force from 6 April 2014.
In deciding if someone is a salaried member, HMRC will examine
- The degree of control the LLP has over the individual;
- The amount of economic risk borne by the individual;
- The requirement for personal service;
- The extent to which the individual can profit from sound management; and
- The individual’s entitlement to a share of profits or surplus assets if the LLP were wound up.
If fixed profit share partners are classed as employees, they will have to pay income tax through PAYE on the same monthly basis as other employees, while the LLP will have to pay Class 1 national insurance on their salaries. Considering that LLP members often have relatively senior salaries, a 13.8% tax could amount to a considerable expense. As some measure of consolation, the LLP will gain the ability to deduct the additional salary costs when calculating taxable profits.
It is therefore important that LLPs review their fixed profit share agreements and working practices to consider if any changes are required, such as capital contributions, and increased share of profit.
Companies that pass wealth to owners through a partnership
The government has a 25% corporation tax charge on close companies (generally speaking, companies that are controlled by five or fewer people) where they transfer funds, via an intermediary partnership, to the individuals who control it (known as participators). Recently HMRC updated its legislation to close loopholes which were allowing some company loans to be maintained tax free.
For further information on these changes, you can read Menzies’ article on Changes to Close Company Loans to Participators.
Consultation around changes to partnerships
One of the commercial advantages of operating as a partnership is the flexibility it offers. There is no requirement that funds be distributed in proportion to an individual partner’s level of involvement, effort or capital contribution. Fund allocation can vary from year to year, and there is no need for profits and losses to be shared in equal proportions. This considerable flexibility has allowed partnerships to share profits in a very tax efficient manner.
However, HMRC believes that some partnerships are manipulating profits and losses to achieve a tax advantage, and so is introducing counter measures.
The three main areas of concern they are looking at, are:
a) Partnerships with mixed members (typically companies and individuals) where profits are allocated to a member that pays a lower rate of tax;
b) Partnerships with mixed members where losses are allocated to a member that pays a high rate of tax; and
c) Partnership arrangements where members reduce their profit entitlement in return for payment made by other members who will be taxed more favourably on those profits (partnerships with members with differing tax attributes).
Mixed membership partnerships should review their structure to see if they are likely to be affected by the proposed changes. It should be noted that the proposed changes are not intended to affect those entering into arrangements that are not tax-motivated, so it maybe appropriate to document the commercial reasons for the current structure.