Evolving structures: Why your law firm should convert to a hybrid LLP

UK law firms should consider adopting the corporate LLP hybrid model, suggest Baker Tilly tax experts George Bull and Mark Waddilove

On 6 April 2001, limited liability partnerships (LLPs) came into being after almost eight years of consultation and preparation by two different governments. This was hailed as the first major addition to the types of legal vehicles available under UK law since joint stock companies were established in 1844. Since its introduction, it has been the vehicle of choice for most law firms, but can this continue?

Take the fictitious example of law firm ABC LLP. The new finance director calls a meeting to present a proposition to the members of the executive committee, which represents the partners of ABC. The proposition on the boardroom table is only a dozen pages. Printed on crisp white A4 sheets, it is bound neatly and on its cover are printed just nine words: “alternative business structures – a new way to do business”.

Most of the senior partners of the executive sitting around the table have seen such statements before and are sceptical. The ABS commencement date, 6 October 2011, is fast approaching and they are still no closer to finding the ideal structure for their business.

They have looked at all of the usual suspects and are universally agreed that nothing really exists that will help them to structure their business to meet all of their strategic goals while delivering the tax efficiency and business flexibility they currently enjoy. Can this proposal really be the panacea for them and the rest of the legal business world?

The FD begins the presentation with a summary of the business structures already considered by the executive and how they compare with what the proposition calls a corporate LLP hybrid (hybrid LLP).

Catalysts for change

ABC law firm has been an LLP for a number of years and its executive committee are fully aware of the benefits this provides over the traditional general partnership, which is slowly disappearing from the UK business landscape.

Like most law firms, ABC is operating on the tenancy partnership model, whereby partners receive income distributions throughout their term but receive no capital return when they leave (other than the return of capital they contributed to the firm). They paid nothing to join the partnership and therefore expect nothing when they leave.

However, the senior partners and junior partners are demanding change, and the executive have been charged with the responsibility of delivering a structure that fits with their recently-ratified strategy of sustained growth and talent retention.

The modern law firm is changing, partners are looking towards the future, perhaps towards equity participation structures, in which the capital value of the firm is realised and allocated to partners in quantifiable shares.

The executive look at the proposition in front of them and agree that, although the Legal Services Act and the imminent arrival of ABSs should be the catalyst for their change in strategic direction, cashflow and increasing UK income tax rates are significant drivers that demand a root-and-branch review of their current business model.

The partners in the executive have often argued the merits of equity participation and, although the drawbacks of a traditional limited company have prevented any move to full incorporation, the recent divergence of income tax and capital gains tax make the argument compelling.

Financing challenges

The business of ABC is also in need of urgent financing to help fund an ambitious information and communication technology (ITC) upgrade. The partners have already asked their bank and the amount on offer is significantly short of their requirements.

Self-funding is one option, but to fund a £1m ITC investment out of profits taxed at 52 per cent means the partners must earn circa £2.1m.

The corporate option significantly reduces this burden to circa £1.3m when the corporation tax rates fall to 24 per cent, but the additional employment expenses are a high cost to pay.

If the bank is unable to help and the cost of self funding is too high, do they have any options other than to look for external funding via an ABS?

The arrival of ABSs in less than six months provides an alternative means of raising capital. Although ABC’s executive are not happy with the prospect of outside interference, if equity interests could be traded between partners and potentially sold to third party investors, a solution to their finding crisis could be found.

These equity interests could entitle the holder to participate in ‘capital profits’ generated by the sale of all or part of the firm’s business or any of its capital assets. An equity interest could also be retained by a retired partner (either for a fixed period or indefinitely), allowing participation in capital profits realised after retirement to reward their contribution to the business.

This catches the interest of the senior partners of the executive who are fast approaching retirement and so are keen to hear more of the proposal.

As they turn the pages, the proposal continues to highlight the benefits of a capital partnership model to include the direct incentivisation of partners to grow the capital value of their business, and the realisation of that value at the more favourable capital gains tax rates.

However, the executive had considered this in the past and were concerned that realising goodwill can create divisions between different generations of partners, with the prospect of junior partners being required to pay large capital sums to retiring senior equity partners, causing inevitable tensions.

They are an ambitious practice and growth is still a major driver in the strategy. They have not ruled out mergers or acquisitions, but are very aware that it is notoriously difficult to broker a merger between a firm with a goodwill scheme and one where no consideration is being paid.

For these reasons, the executive have previously considered how they would share capital profits on a capital event without actually changing their structure. They have looked at updating their LLP agreements to include a ‘phantom’ or ‘shadow’ equity scheme in anticipation of future change. However, they are not particularly tax efficient and raise interesting issues regarding the division of equity.

The hybrid LLP

So how can the firm combine all of the advantages of its existing LLP structure with the corporate benefits of a traditional limited company?

The FD explains that the corporate LLP hybrid is a structure that enables the firm to continue to provide legal services through its existing LLP, but transfers and operates its governance and control through a limited company. The shares in the company are held by the partners of the LLP.

The corporate member will also allow the partners to build up reserves, possibly to use as an acquisition ‘war chest’ for any potential acquisitions, or to address their short-term funding needs for the ITC project.

The recession has highlighted how many law firms have found themselves undercapitalised. The FD explains to the executive that the days of the ‘full distribution’ model of partnership remuneration are probably behind them.

As retaining profits in an LLP is not particularly tax-efficient, admitting limited companies as ‘corporate members’ to mitigate the tax charges on retained profits makes a great deal of sense. Corporate members also bring many planning opportunities for the business and the partners.

The structure by which the corporate member (Newco) is admitted would be similar to a leveraged buyout, with the partners providing the financing (although Newco can also borrow funds). Newco could pay the partners for their capital interests out of Newco’s share of the firm’s future profits. It would be liable to corporation tax at up to 26 per cent, but with planned reductions to 24 per cent by 2014/15. Partners’ profit shares are likely to be reduced, but drawings and cashflow could be maintained by Newco paying each partner for his or her share of the capital interests in instalments.

Structuring the ownership of the corporate member will require careful consideration, since it will be acquiring an interest in the LLP. This will change the tax profile of the firm. The partners could sell some or all of their capital interests to the company. A profit on a sale of a capital interest in the firm would be subject to capital gains tax. However, it is likely that partners would be able to claim entrepreneurs’ relief, with a 10 per cent tax charge on the first £10m realised gain.

Back at the presentation, the finance director is summing up. The main thrust is that creating a hybrid LLP will make the business more competitive and more likely to prosper in what are very uncertain times.

The finance director reminds them that the proposed structure not only affords potential capital benefits for partners but also employees through HMRC-approves share schemes, making them attractive to all levels of lateral hires – as well as ensuring existing talent is motivated to stay and grow the business.

This, together with the prospect of being self-funding in a tax-efficient way, retains all the personal tax and business tax benefits, make the hybrid LLP an extremely attractive proposition.

If ABC’s executive committee agree to the FD’s wishes, they will not be alone. Several firms have already either restructured as a hybrid or are in advanced discussions to become one shortly before or after ABS day. It is only a matter of time before hybrid LLPs are commonplace and are possibly the new business vehicle of choice for the contemporary law firm.