Restructuring LLPs: The ownership issues affecting your law firm's future structure

The first article in this series on new business structures for law firms following the UK’s LLP tax reforms set out the changes to the regime under the Finance Bill 2014. The Supreme Court’s recent decision in Clyde & Co LLP v Bates van Winklehof (in which the court decided that a member of an LLP could be a ‘worker’ for the purposes of whistleblower protections) has given rise to yet more debate about the merits of the LLP versus the limited company as the best vehicle for structuring professional service firms (PSFs).

This analysis is not straightforward and each law firm needs to consider its particular circumstances. For some, the limited company will be appropriate, for others it will be the LLP. Some still find that a general partnership works best for them. Interestingly, the limited company structure is far more prevalent in other professional service sectors, such as real estate consultancy and architecture. What is clear, however, is that the decision on legal entity should not be driven by the tax analysis in isolation, or by the redefinition of LLP members as ‘workers’ or otherwise.

The first article in this series gave an overview of the issues to be considered
in choosing the most appropriate business vehicle for your law firm. The second article then looked at the importance of strategy, while the third article explored culture and how that might impact entity selection. Here, we consider ownership and the ways in which different ownership models drive structures. The fifth and final article in this series will explore the impact of remuneration.

The most important drivers of structure from an ownership perspective are:

• third-party investors in the firm (or the prospect of introducing them);

• the need for flexibility, for example to admit and terminate members or adjust ownership interests;

• the commercial sensitivity of ownership arrangements; and

• group structures and international considerations.

We shall look at each of these in turn.

Third-party investors

There is a perception that private equity and other investors are reluctant to invest in law firms structured as LLPs. However, of the two most significant PE investments in the legal sector, one was in a limited company and the other an LLP. Parabis was already a limited company when Duke Street approached it. Knights was an LLP when it struck its deal with James Caan’s Hamilton Bradshaw and continues to trade through an LLP.

Law firms have not long been targets for external investment. Third-party investors are therefore much more used to investing in limited companies. Serial investors will have standard protections that they are used to writing into contractual articles and shareholders’ agreements, such as information and consent rights, pre-emptions and ratchets. They are also more familiar with financial reporting from limited companies than from LLPs. There is an assumption that a limited company will be operated more as a ‘corporate’. Investors
will always have an eye on exit opportunities. If they are uncertain about LLPs, they assume others will be as well.

Apart from the latter, there is little substance to these concerns. Investors can obtain equivalent protections as members of an LLP, financial reporting can easily be ‘translated’ and a ‘corporate’ governance regime can be applied to an LLP. Indeed, many PE firms are themselves structured
as LLPs and have outside investors. Despite this, it does appear that most investors are more comfortable with investing in a limited company than an LLP, though this feels like something they should be open-minded about.

If your firm has an outside investor, you are very likely working in a limited company. If you may have an outside investor in future, a limited company structure may make that process easier. If, on balance, having considered all of relevant factors, an LLP still makes sense for you, do not assume that it will put off investors. Some will take the time to understand the issues and, if they do not, you could move your business to a limited company as part of the investment process.

If you opt for a limited company structure, that does not mean that an LLP cannot also feature. Some firms, such as Slater & Gordon, have a company at the top of their structure but conduct their trading business through LLPs. Despite recent changes to the tax treatment of corporate members in LLPs, mixed partnerships remain an effective model in many circumstances.

Owner managers

One of the principal advantages of the LLP over the limited company is its flexibility. The admission and termination of members is relatively more straightforward, as is adjusting equity interests between members. The LLP’s statutory regime gives considerable latitude to members to agree the governance and membership arrangements that best suit them.

For example, a recalcitrant partner’s membership can simply be terminated, subject to fiduciary duties and the principles of natural justice. Equity interests can be reallocated between members without giving rise to capital gains tax charges.

Though better understood and more clearly defined in law, the Companies Act sets out a more stringent framework for limited companies. Governance and decision making must conform. Shares have to be issued, transferred or cancelled, each process requiring more consideration than the creation, transfer or termination of an LLP membership interest. The transfer of shares between members may be a taxable event. Adjusting ownership interests is more difficult. Though the
traditional law firm model can be recreated in a limited company, the legal arrangements will inevitably be complex – hammering a square peg into a round hole.

Where a firm is owned by a small number of partners whose interests are fixed, the limited company model could
be suitable. The flexibility of the LLP may well not be a priority. Larger firms, particularly those with a relatively high turnover of partners or where ownership interests are adjusted regularly, are likely to find the constraints of a limited company structure frustrating.

Firms in which interests are fixed would do well to look to the future. The limited company structure may be adequate for the time being, but law firm owners should always have succession in mind. For example, are the owners planning to bring in junior partners and gradually transition equity to them,
or sell out in one go on retirement?
The former would be easier to achieve
in an LLP.

The debate about structures often involves discussions about the ‘goodwill’ and ‘tenancy’ models of partnership.
Most PSFs now have a tenancy model – new partners contribute capital on admission, receive a profit share during the tenancy of their partnership and,
when they retire, receive back their capital. With the goodwill model, new partners buy-in on admission and sell out on retirement, receiving the benefit of any increase in value of the partnership (or suffering any decrease). Either structure can be accommodated equally easily
in an LLP or a limited company. When it comes to legal entity, this is a red herring.

Disclosure issues

Firms that use the LLP model are, for the most part, used to the disclosure requirements which are the prid pro quo
of limited liability. Their accounts are public, as are the distributions to their highest earning member.

However, there are certain matters that LLPs can still keep to themselves. In particular, whilst the identities of the members are known, the nature of their ownership interests are not a matter of public record. Profit per equity partner can be determined from the accounts, but the proportionate interest (and earnings) of each member are private. Similarly, to the extent that capital and income profits are separated, that will be a private matter. This is, however, subject to the outcome of government proposals to require UK corporate entities (including LLPs) to disclose information relating to beneficial ownership.?

With a limited company, the shares held by each owner are a matter of public record. Interested outsiders will be able to track changes of ownership, which may reflect the performance of a partner over time. Variations in income could be achieved through salaries and bonuses rather than shifting ownership interests;
this would ensure confidentiality, but it would not be tax efficient.

Larger structures

Fifteen years ago, most law firms had a very simple structure, most likely a single general partnership through which all of their activities were conducted. Now, it is not uncommon for firms to have separate vehicles for different service lines and, for international firms, multiple branches and entities in jurisdictions across the world.

In the vast majority of cases, ownership ultimately remains with a central holding LLP or company, even if trust and nominee arrangements are used for overseas entities. However, there are circumstances in which ownership might be separated,
for example where a particular partner wishes to invest in a non-core service line, or where the main partnership does not want to take the risk of establishing a presence in a new jurisdiction. In recent years, international mergers have given rise to decentralised ownership, for example
the verein structure used by DLA Piper
and Hogan Lovells.

These ownership factors will all drive decisions on structures, but not necessarily the choice of a limited company or LLP as the UK operating vehicle. That decision will be made on the same basis as for a firm with a simpler structure and, of course,
with consideration of the tax issues.

Structuring for success

Each firm’s circumstances will differ,
and so will its legal structuring analysis.
The key is to take all of the relevant factors into account, including culture, strategy, ownership and remuneration.

Tax will also be central to any decision, but it should never be considered in isolation. For many firms, the decision is relatively finely balanced but, if you have examined each of these issues carefully,
you will be able to make the best decision for your firm and you will have structured it for success.

Aster Crawshaw is a partner in
the professional practices group at
international law firm Addleshaw Goddard
(www.addleshawgoddard.com)