LLP vs. Ltd Co: Restructuring your firm in light of the UK LLP tax changes

Much has already been written about the review by HM Revenue & Customs of the taxation of UK limited liability partnerships (LLPs). Some commentators welcome the forthcoming changes introduced by the Finance Bill 2014 as an overdue response to immoral tax avoidance. Others view the new rules as a cynical revenue-raising exercise. But, irrespective of your viewpoint, change is coming. And it is coming faster than most partnerships would like.

Understandably, many firms carrying on all or part of their business through a partnership or an LLP have already begun reviewing their legal structures. Changes to the tax rules could have a significant impact on distributable profits, so it is not possible to divorce tax from any discussion regarding the optimum structure through which to operate a business. However, in most cases, tax should not be the only (or even primary) consideration. So, what other factors should you consider?

1. Strategy

The legal structure of a business should facilitate its strategic ambitions. Structure should not drive strategy, nor should
it constrain it. Before considering
whether an LLP or limited company
(or indeed any other form of business vehicle) is most appropriate for your business, it is important to be clear
about your strategy.

On the assumption that this strategy involves growth (by reference to revenue, profit, geographical coverage, headcount, breadth of service offering or any other metric), is this likely to be achieved by organic growth or merger/acquisition? Can it be self-funded (by retained profits or loans or capital contributions from members) or will it require external debt or equity finance? Are your expansion plans domestic or international? Or are you priming the business for sale?

2. Culture

Does the business have a particularly distinct culture or ethos? Do decisions about the business tend to be made collectively, reflecting a collegiate partnership approach, or has a more corporate management structure been adopted? Would it be beneficial to have the flexibility to designate different voting levels for different decisions, to restrict voting on some issues to certain classes of member and/or to introduce weighted voting rights in certain circumstances? Is information about the business (including financial performance, reward and equity ownership) disclosed, or is it beneficial to restrict access to this information as much as possible (both internally and externally)?

3. Ownership

Is the equity ownership of the business vested in a single individual, a group of individuals, or is it spread more widely? If there is more than one entity in the group, or distinct divisions within an entity, would it be advantageous to split equity ownership in different proportions between the different entities or divisions? Are the proportions in which the equity is held frequently adjusted (by transfer or fresh issue) and is this a means of incentivising senior individuals?

What is the age profile of the equity participants? Are there succession issues and the corresponding need to spread the equity amongst the ‘next generation’ or introduce broader employee ownership?

4. Financial reward

Is the remuneration of senior individuals largely fixed by reference of the performance of the business as a whole from year to year, or does it vary depending on their own personal performance or the performance of a particular division? Are there different tiers of senior individuals, each with different levels of entitlement? How much flexibility is required in respect of the amount and timing of distributions during the financial year?

 

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Finance Bill 2014

Proposed changes to the taxation of LLP members are outlined in the draft Finance Bill 2014 (published on 10 December 2013), due to become effective from 6 April 2014. HMRC guidance has also been published. The changes will affect LLPs in all sectors, including law, accountancy, financial services and real estate.

The proposed changes mean that, where all of the relevant conditions set out below are met, members of LLPs will be taxed as employees. This means that the profit shares payable to such members will be subject to pay-as-you-earn (PAYE) tax and class 1 national insurance contributions (NICs).

An additional 13.8 per cent of employer’s NICs would need to be paid by the business as a social security charge on the member’s income. The additional NIC costs would reduce distributable profits. This would also have cashflow issues as these amounts, as well as a member’s liability to income tax, have to be paid monthly through PAYE. All affected members would also be re-categorised as employees for tax purposes, which would affect their personal pension position.

 Unless one or more of three conditions are failed, an LLP member will be determined to be an employee for tax purposes.

The relevant conditions are:

A. The member performs services for the LLP and it is reasonable to expect that the amounts the member receives in return are wholly, or substantially wholly, ‘disguised salary’. Disguised salary is defined as remuneration which is fixed, or variable without reference to an LLP’s overall profits, or is not in practice significantly altered by the overall amount of an LLP’s profits. Notwithstanding that a fixed share may abate where there are insufficient profits, the guidance states that, where any repayment is unlikely, the amounts will qualify as “disguised salary”.

B. The member does not have significant influence over the LLP’s affairs; and

C. The member’s capital contribution to the LLP is less than 25 per cent of the member’s “disguised salary” in the relevant tax year.

These provisions apply after 6 April 2014 and existing LLP members will be assessed on whether or not they fail one of the conditions as at that date. New members will be assessed on the date they became members of the LLP.

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Structural review

Set out above are just some of the questions that you should be asking when determining the optimum legal structure for your business. Each of the four elements referred to will be explored in more detail in the remaining articles in this series.

In very broad terms, LLPs provide greater flexibility than companies limited by shares in a number of respects.
This includes:

• governance flexibility (avoiding the separation existing in companies between the roles and duties of shareholders and directors);

• greater freedom to distribute profits and return capital;

• ease of admission and termination of membership (due both to the simpler mechanisms available for creating and transferring equity interests;

• the absence of employment law in respect of self-employed members); and

• reduced publicity and compliance requirements.

Notwithstanding the above, many businesses find greater comfort in being able to rely on the well-established statutory framework applying to limited companies. There is a degree of imposed formality, and associated rigour in terms of operating the business, that may be attractive. Securing a loan or external investment, or selling the entire business, may prove to be more straightforward. A private company limited by shares will, in particular, be a more familiar entity in most foreign jurisdictions.

It is evident that there is no one-size-fits-all solution. For this reason, it may
be too simplistic to concentrate solely
on the prevailing tax rates, however significant their impact on distributable profits, when reviewing the legal structure of your business.

Each type of legal entity will have its own advantages and disadvantages. It may also be possible to combine different entities within a corporate group in order to take advantage of the respective benefits, and mitigate the respective limitations, of each. But, whichever structure you ultimately adopt, it is critical that the decision is taken after a thorough review of all the relevant factors and with the ambitions of the business foremost
in mind.

Jonathan Cheney is a partner in the professional practices group at Addleshaw Goddard (www.addleshawgoddard.com)