What Changes When You Become Partner and How to Prepare for Them

Becoming a partner at a law firm is a significant achievement and a monumental stepping stone in any career. While it is certainly a milestone to celebrate, it also marks a time of change and adjustment.

When making the transition to partner, you will need to develop an understanding of the key financial information you will now see, changes in the way you will be taxed and how to use your earnings as efficiently as possible and prepare your finances for retirement. 

Accounts and management

Becoming a partner within a law firm inevitably comes with increased responsibilities and pressures. These include the demand to bring in new work, introduce capital to the Limited Liability Partnership (LLP) and, underpinning all this is the fact that, as a member of the LLP, you are an ‘owner’ of the business which comes with certain responsibilities.

Understanding of the financial information presented to partners is essential in ensuring that you are able to meet the financial performance expectations placed on you internally by the firm, as well as meeting your statutory responsibilities as a member of the LLP.

To navigate this, a new partner is required to have a degree of financial literacy that, quite possibly, training and experience to date have not provided.

The LLP is required to prepare and file financial statements. For entities of a certain size, these will need to be audited. While this task will usually be performed by the finance team, as a member of the LLP, you are legally responsible for truth and fairness of its financial statements.

From an individual perspective, you will need to be able to understand certain metrics that are used to measure performance targets, both for the partnership and its members and to understand the management information provided internally, in order to understand how you will share in the firm’s profits.

To navigate this, a new partner is required to have a degree of financial literacy that, quite possibly, training and experience to date have not provided.

Types of financial information

On a basic level, a partner will need to identify what financial information is being reviewed, and have an understanding of the terminology used in each situation. These include:

  • Statutory information/ LLP Financial Statements – aimed at reporting the performance of the LLP as a whole to external stakeholders
  • Partnership accounts – intended for internal use. This will include detail of the individual partners, allowing them to see their capital position, profit shares, current accounts and tax reserves.

Both of these are based on the same underlying financial information, but their structure, presentation and the information that they convey can be very different.

What a partnership accounts include will vary on a firm to firm basis.

Financial statements

  • Profit and loss account – shows the profit the firm has made in the year.
  • Balance sheet – shows the firm’s assets and liabilities, as well as its capital and equity at its balance sheet date (e.g. a single point in time).
  • Cash flow statement – shows how the firm has managed its cash. This statement is often overlooked, but it is very important.
  • Reconciliation of members’ interests – shows, in summary, the transactions with the members as a whole, including movements in capital, the profit for the year and drawings.
  • Notes to the accounts – other supporting information including the accounting policies and further information on items in the profit and loss account and balance sheet.

Partnership accounts

What a partnership accounts include will vary on a firm to firm basis. Some firms refer to these as the management accounts, but generally, they will best present the information about how the firm wants to manage the business, which may be by departments or divisions, or even individual partners. They may even apply a different approach to the recognition and disclosure of certain items that differs from the approach in the statutory financial statements.

Importantly, they will also include the following information relating to each partner.

  • Current account – records profit share together with drawings paid and other personal expenses paid on behalf of the partner. The balance represents the amounts that the partner should expect to be paid out. Firms will have different policies on when this balance is paid.
  • Capital account – long-term investment in the firm. This may be a fixed amount or may increase with points. It is often financed by a personal loan from a bank.
  • Tax reserve – a record of tax charged against partners’ profits fewer tax payments to HMRC on behalf of the partner. The complexity will depend on year-end.

An employee has their tax and NI deducted under PAYE each month.

Partnership tax

Being promoted to a partner affects the way in which an individual is taxed. They are no longer an employee with a known salary and all the associated employee benefits. Instead, they are a self employed partner with a taxable profit share which may be different from their accounting profit share. As an employee, the firm would have paid the employer’s National Insurance (NI) on the salary paid. There is no similar payment due by the firm in respect of self employed partners.

If the partner has not previously completed UK tax returns, they will need to do so going forward, with the filing deadline 31 January following the end of the tax year if the return is filed electronically. In addition, appropriate forms will need to be completed, advising HMRC that they have become a partner in the firm.

An employee has their tax and NI deducted under PAYE each month. However, for a partner, tax and NI are paid in three instalments:

  • The first payment on account, due 31 January in the tax year, and is based on 50% of their previous year’s tax liability
  • Second payment on account, due 31 July after the end of the tax year, and is based on 50% of their previous year’s tax liability
  • Balancing payment, due 31 January after the end of the tax year, and is the actual tax and NI due to fewer payments on account.

Therefore, for a new partner who was previously an employee, it is unlikely that in their first year they would have to pay the first and second payments on account, as these are based on the previous year’s self assessment tax liability. Therefore the amount due 31 January after the end of the first tax year, will be the tax liability for the tax year plus a further 50% in respect of the following tax year’s first payment on account.

A partner is assessed for tax on their share of taxable profits, not on their share of accounting profit.

What is a partner’s profit share? How is it paid?

There is likely to be an agreement to the level of drawings that are paid out on a monthly basis but the level of profit share may not be fixed and there may be a variable element dependent on a number of factors which could cover performance of the individual partner, their team, their office and the firm as a whole.

How are partners assessed for tax?

A partner is assessed for tax on their share of taxable profits, not on their share of accounting profit. Accounting profits are not necessarily the same as taxable profits because there are a number of adjustments which may be made. The nature of the adjustments that apply include, for example:

  • Personal partner expenses (e.g. private commuting costs, lunches, private medical insurance, life assurance)
  • Capital expenses (e.g. costs in relation to changes in relation to the partnership agreement)
  • expenses which are specifically disallowable (e.g. entertaining clients and contacts)
  • Timing differences (e.g. depreciation in the accounts is disallowed and instead capital allowances are claimed).

New partners are taxed on their taxable profit share from the date of commencement to the following 5 April and, in future years, they are taxed as a continuing partner.

Invariably, the taxable profits are higher than the accounting profits and partners will be paying tax on amounts more than those they have actually received.

On what basis is a partner taxed?

For a continuing partner, they are taxed on their share of taxable profits in respect of the accounting year ending in the tax year.  

New partners are taxed on their taxable profit share from the date of commencement to the following 5 April and, in future years, they are taxed as a continuing partner. If there is no 12 month accounting period ending in the second tax year, then it is the first 12 months.

If a firm has a year-end other then 31 March, then overlap relief profits will be generated. Overlap profits are taxed twice initially, but when a partner retires or leaves the firm, they deduct their overlap profits from their taxable profit share in the year of their retirement or exit.

 It is usual when you become a partner to contribute capital into the business.

Tax reserving policies

The majority of law firms (generally excluding US law firms) will have tax reserving policies in place to deal with partners’ future tax liabilities.

If a firm reserves on behalf of its partners, then it removes the hassle for partners of having to place money to one side and arranging for their tax liabilities to be paid personally. The firm benefits as the tax reserves will help finance working capital.

The firm may reserve for tax solely on partnership income, or it may reserve tax on personal income as well.

For a firm with a 31 March year-end, the tax charge will be the tax liability arising on the corresponding taxable profits, the provision in the accounts will be the second payment on account, due 31 July after year-end, plus the balancing payment due the following 31 January.

For a firm with a year-end other than 31 March, the key question is on what basis will tax be reserved? There are effectively three choices. If a firm has a year-end of, say, 30 April 2020, the choices are:

 

  1. Provide for the 2019/20 tax liability only (under reserving)
  2. Provide for the 2019/20 tax liability plus the retirement fund (prudent)
  3. Provide for the 2019/20 and 2020/21 tax liabilities (excessive, overly conservative).

Often the capital contribution is borrowed by partners and firms usually have a working relationship with their bankers to provide a competitive rate of interest.

The second option is the most favourable, as it is prudent, is not excessive and there will be no hidden tax liability surprises that will come into play at a later date. The tax charge in the example will be the 2019/20 tax liability, plus the additional tax on the retirement fund (e.g. the tax on the taxable profits for the year ended 30 April 2020 less overlap relief brought forward). This poses the question of what rate of tax will be used in calculating the tax on the retirement fund? The rate used is up to the firm, but it is likely to be 42% or 47%. However, if profits are just over the £100,000 mark and the possibility of a 60% tax charge, then neither of these rates may work.

Funding a capital contribution

It is usual when you become a partner to contribute capital into the business. Due to salaried members legislation, it is key that capital contributed by new partners is paid into the firm within two months of becoming a partner, if the firm is an LLP.

Often the capital contribution is borrowed by partners and firms usually have a working relationship with their bankers to provide a competitive rate of interest.

Partners will receive tax relief on the interest paid on their borrowings. It may, therefore, be beneficial to pay off other loans before the loan to contribute capital or even employ funds elsewhere to achieve a superior rate of return.

Once you cease being a partner there is no tax relief available on interest paid after that date. Therefore, care needs to taken when capital is repaid.

The secret to success is to commence making pension contributions at your earliest opportunity so that you get into the discipline of saving and benefit from the generated income tax reliefs associated with pension contributions.

Financial Planning

The transition from employed to self-employed when becoming a partner means that, for many, all of the employee benefits that you previously took for granted now disappear, and you are left to make your own provision.

This is particularly relevant to pension contributions, where you will no longer be eligible to join the firm’s scheme and benefit from employer contributions, but instead, have to pay these contributions personally.

The secret to success is to commence making pension contributions at your earliest opportunity so that you get into the discipline of saving and benefit from the generated income tax reliefs associated with pension contributions. These can be as high as 45% for higher rate taxpayers. This means that for every £10,000 that goes into your pension fund, the net cost to you will be just £5,500, and there is no better tax-efficient way to save for your retirement.

However, the annual allowance for pension contributions (the maximum you can contribute in to pension funds and benefit from tax relief) is just £40,000 per tax year. This allowance is then reduced for those individuals deemed to be ‘high earners’ by £1 for every £2 of income between £150,000 and £210,000 so that, for individuals earning in excess of £210,000, the annual allowance is restricted to just £10,000.

Depending on where you are in your earnings journey, you may need to prioritise pension contributions in the early years of partnership, as your funding options may become restricted as your earnings grow.

There is also the opportunity to carry forward any unused annual allowance from the previous three tax years. Individuals may be able to ‘catch up’ on past payments and still benefit from 45% tax relief. A calculation should be done to determine any unused allowances and to establish your capacity for making pension contributions.

Newly appointed partners should also check on whether they benefit from arrangements, such as partner life insurance, income protection and private medical insurance. If these insurances are not offered by the partnership, then you need to consider your personal requirements and take out private cover.

The appointment to partner provides you with the opportunity to review your financial planning and use your earnings to your best advantage.

Other aspects need to be considered, such as:

  • How easy (or otherwise) it is to obtain a mortgage now that you have become self employed, your strategy for repaying any mortgage debt
  • Alternative savings options for retirement such as Individual Savings Accounts (ISAs), cash reserves
  • Other tax advantaged savings vehicles such as Venture Capital Trusts (VCT) and Enterprise Investment Schemes (EIS).

It is important to remember that pensions and ISAs are merely tax structures and that it is the underlying investment strategy that is key to the success of your planning. Having a good understanding of where your monies are invested and how these reflect your attitude to risk and capacity for loss are of paramount importance.

The appointment to partner provides you with the opportunity to review your financial planning and use your earnings to your best advantage. Specialist advice should be sought to ensure that you are optimising the tax efficiency of your planning and are on track to achieve your financial objectives. For more information,  you can access Crowe’s free, on-demand webinar series here.

 

Written by Nicky Owen, Partner, Professional Practices, Phil Smithyes, Partner and Head of Financial Planning and Ryan Ketteringham, Director, Corporate Audit at national audit, tax, advisory and risk firm, Crowe.

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