We are often asked to advise our Professional Services clients on the optimal operating model: LLP or limited company (LTD).
Whilst the statutory and accounting filing requirements are similar across both structures, the LLP was introduced to offer flexibility in management and pay: both important in human-capital-intensive Professional Services Firms. An LLP is controlled by its Members and governed by the Members Agreement, whilst a company is controlled by its shareholders under the articles of association and shareholders’ agreement.
Soon after their introduction, LLPs became the go-to model for Professional Services Firms because of the ability to:
- split partnership profits between Individual Members, taxed at income tax rates, to reflect profit or performance targets;
- appoint a Corporate Member to absorb “excess partnership profits” in a given financial year, taxed at a lower (corporation) rate of tax and available for reinvestment in the business;
- appoint and remove partners without the complex process and costs of them conferring or relinquishing shareholdings, and without the tax costs were any shares obtained at undervalue.
We know that LLPs are tax transparent and that Individual Members are usually treated as self-employed and taxed at income tax rates, subject to HMRC tests. On the contrary, a company pays corporation tax on profits: a company’s directors receive salaries subjected to PAYE whilst its shareholders pay income tax on dividends voted by the directors.
Some of the benefits of an LLP therefore centre around the following:
- An Individual Member of a trading LLP is taxed as if they are carrying on a trade directly for income tax purposes. This treatment carries certain tax advantages compared to the treatment of employees:
- Expenses are generally deductible for tax purposes if they are wholly and exclusively incurred for the purposes of the trade. This is in comparison to wholly, exclusively and necessarily incurred for employees.
- Pay as you earn (PAYE) does not apply and tax is generally only payable twice yearly rather than monthly as the individual members are not employees.
- Employer national insurance contributions (NICs) (currently 13.8%) are not payable in respect of the amounts payable to the individual members of the LLP as they are not employees.
- Members can flexibly adjust how the LLP is governed as Members arrive and leave and how Members are remunerated.
Pre-2014: LLP the way to be
Previously and in accordance with a Profit Sharing Agreement (part of the Members Agreement), LLPs enjoyed the ability to apportion taxable profits between Individual Members and Corporate Members, who pay contrasting rates of tax (sometimes 45% vs 19%). LLPs proved to be an effective structure for the governance of a Professional Services Firm, whilst also offering a “hybrid model” of taxation, whereby Individual Members were taxed at income tax rates on income drawn and presumably spent, whilst Corporate Members were taxed at a lower corporation tax rate on excess profits retained for capital expansion of the business.
Post-2014: LLP attack
The mixed membership partnerships anti-avoidance legislation of Finance Bill 2014 brought about a significant change in partnership taxation. Leading up to the change in law, it had become relatively common to see partnerships (including LLPs) with mixed Individual and Corporate Members. In short, the legislation provided for profits allocated to a non-individual partner (B) in a mixed member partnership to be reallocated to an individual partner (A), such that they are taxed at the individual partner’s rate of tax, if either:
- Condition X: it is reasonable to suppose that:
- B’s profit share includes an amount representing A’s deferred profit; and
- A’s profit share and the total amount of tax for which A and B are liable (relevant tax amount) are lower than they would have been absent the deferred profit arrangements.
- Condition Y: B’s profit share exceeds the appropriate notional profit, A has the power to enjoy B’s profit share and it is reasonable to suppose that:
- B’s profit share (or part of it) is attributable to A’s power to enjoy; and
- A’s profit share and the relevant tax amount are lower than they would have been absent A’s power to enjoy in B’s profit share.
Almost overnight, the mixed membership partnership rules led to a decrease in the popularity in the use of LLPs with Corporate Member structures amongst the SME business community and in some cases the unwinding of existing LLP structures.
For mixed partnerships, the following steps could be considered:
- Outright incorporation. This clearly removes the issue of reallocation and provides a deferral of higher tax rates while the company retains the profits.
- Eliminate the corporate members and accept the income tax result. This in effect concedes the full impact of the new rules, so could be combined with exploring other approaches.
- Establish a company owned by the partnership to operate the business with or without the capital assets, ie the corporate is a subsidiary, not a partner. This may provide a possible solution in allowing ownership to change in a partnership rather than a share capital company, but with suitable profit retention for working capital by the operating company.
- Retain the existing structure with corporate members’ shares in amounts that can be justified by the new rules for services or the provision of capital.
- Consider the use of alternative business structures which should not result in reallocations between partners. These require specialist consideration by reference to the case and a range of other relevant legislation.
Clearly the tax effects of making a change will need full review, such as the availability of incorporation relief from capital gains tax, stamp duty land tax, and the impact of entrepreneurs’ relief. You can rely on our expertise surrounding companies, partnerships and tax for the delivery of the sound ideas needed to put plans into action:
- We help businesses manage all aspects of structure from set-up and management to dispute resolution and exit strategies
- We look at tax structures
- We understand the differences in structure between a partnership and a company;
- We advise on adapting a structure that is no longer fit for purpose.
Contact Mouktaris & Co Chartered Accountants for help planning your Professional Services Firm expansion.