Taxing liabilities: The issues to manage when closing an LLP

 

In the past couple of years, there have been several limited liability partnership (LLP) failures in the legal profession, ranging from the likes of Dewey & LeBoeuf and Halliwells to some much smaller firms. With the recent demise of Cobbetts, the pressure on law firms from their funders will continue.

In virtually all of these cases, the demise of the firm was a matter that had not been fully anticipated when it had been set up or when its last members’ agreement had been agreed. This is often particularly the case in respect of the tax and funding position of the firm. The impact of these events will be far reaching and affect many firms in future.

Prior to the advent of LLPs, when firms got into difficulties, all partners (being jointly and severally liable for the debts of the firm) would work together to find a solution and it was rare that the firm’s bankers suffered any significant losses. Today, the LLP structure enables partners to limit their personal exposure, encouraging them to have a more single-minded point of view. This change can increase the size of the losses on the demise of the firm.

Closing a firm

Let’s start by looking at what happens when a law firm has to close.

There are many reasons why the closure of a firm may arise. These can include difficult trading conditions, slow payment by clients and the failure of an important or a number of important clients.

One common feature that happens upon the closure of a firm is that the existing work in progress and debtors become extremely difficult to collect, often resulting in a substantial loss occurring in the final period. This can be exacerbated by the partners of the LLP no longer having a key focus upon billings and collections upon the failure of the firm.

Another major source of loss for ?a failing firm is the crystallisation of ongoing commitments such as property leases. This is often the main reason why headline losses are stated to be in the tens of millions.

In an LLP scenario, the loss will be ring fenced within the LLP structure and therefore, possibly, no longer a primary concern for the partners of the LLP. An administrator will seek to negate these losses either by pursuing debtors of the business and/or other parties.

Due to the structure of the LLP, the partners themselves may not have a requirement to fund any shortfall, subject to the particular circumstances and the operation of the insolvency rules, particularly the two-year clawback provision for LLPs. The partners themselves are likely to have lost their funds held within the LLP at the time of the collapse but, in many cases, not amounts in excess of that.

Interestingly, the way the tax rules work in relation to LLPs is that, while the loss is contained within the LLP, the actual loss arising up to the cessation of trade before the appointment of administrators is shared, for tax purposes only, between the partners. These losses will be allocated according to the profit-sharing arrangements as if suffered by the partners personally. However, many members’ agreements are silent on how these losses are to be shared and the position may therefore be unclear.

In addition, for tax purposes, ?where there is an overall loss, no partner can be assessed on a profit within any profit and loss allocation. This therefore means that any partner on a guaranteed profit allocation will have this netted off against the allocation of losses to the ?other partners and thus not have any taxable income.

Therefore, while a partner will have lost his capital and any undrawn profits within the firm, he may well have substantial income tax losses available for offset against his personal income. Depending on the circumstances, these losses may be in excess of his current year income as well as that of a number of prior years. The operation of the tax rules means that the individual will be able to offset these losses against his income of the year of the firm’s demise as well as that of up to the three previous tax years. This could potentially generate significant tax repayments – clearly, a valuable asset.

Having set the scene, let’s look at a number of different scenarios.

Salaried partners

It is fairly common for law firms to have more junior partners who are, in effect, on a fixed profit share, subject to a small variable profit amount. These partners will invariably have a guarantee in relation to their fixed share and will have had drawings during the course of their partnership based thereon.

Often, in UK firms, these drawings will have been made to the individual net of his tax liability; the amount reserved for tax will then have been paid over to HMRC in the normal way. It is common for the members’ agreement relating to salaried partners to have not fully considered the position in relation to the collapse of the firm.

Some individuals in this situation ?will naturally be concerned about the impact of the collapse of the firm, their exposure to the debts of the business ?and the consequences of not being ?able to fund their tax liabilities which had been reserved within the firm (and the funding of which is unlikely to be available going forward).

Subject to the timing of the accounting periods and the demise of the firm, it may well be that while the individual had received drawings during the period leading up to the collapse, the firm, for the reasons explained above, may not have made a profit.

The way the tax rules apply is to effectively say that while the profits and losses may be shared between partners according to their members’ agreement, no partner can be assessed on a profit in a year when another partner has a loss and that the two need to be netted off before allocation for tax purposes.

Accordingly, this means that, while the salaried partner will have received his drawings during the year, there will be no profit available to frank that payment and therefore, for tax purposes, he will not have a taxable profit.

Assuming tax payments had been made in accordance with the normal self-assessment procedures, this often means that payments will have been made on account of the tax year within which the demise occurs. Thus, the junior partner moves from a position of being concerned about his inability to fund future tax payments to one where he is actually due tax repayments. This can produce an unintended windfall, as the salaried partner will have received his income gross for the period in question.

This windfall arises at the expense of the full equity partners, as their share of any losses will have been reduced to fund the uplift for the salaried partner. ?It is, however, possible to cater for this scenario within a members’ agreement such that the potential windfall does not impact upon the other partners, but this needs careful drafting.

The firm’s funders

In a number of cases, funders appear to have failed to fully appreciate the full consequences of how they have lent to LLP businesses and may therefore have increased their potential for loss.

Let’s consider a scenario where a law firm is, as normal, funded partly by partnership borrowings from the bank and also partly by capital injected into the firm by the partners. It is normal for a significant part of the capital injected by the partners to have been lent to the partners for this purpose by a bank.

In this scenario, let’s assume that the bank providing the funding to the partnership is different to the banks providing the funding to the individual partners in respect of their capital injection.

So, what happens upon the ?firm’s collapse?

There are likely to be substantial losses arising within the LLP upon its collapse. The administrator will pursue all appropriate means in order to maximise the funds available for distribution to creditors. Where there is a shortfall of assets, the creditors will have suffered ?a loss.

Therefore, in this scenario, the bank funding the partnership will have had a shortfall on its funding and suffered a loss relation to the amounts that are not collected by the administrators.

However, there is value attributable to the loss which was incurred by the firm up to its collapse, in that it has the potential to generate tax repayments. The problem for the bank funding the firm is that these losses are losses of the partners and the tax repayments will go to the partners and not the firm. The tax repayments are therefore not accessible to the administrator or the creditors.

Looking at the position of the individual partners, they will probably have lost the capital they injected into the firm and will have an outstanding debt to the bank that lent them those funds.

The standard first reaction of a partner in such a situation is that he is in dire circumstances, as he owes the bank a substantial sum of money and has lost all of his investment in the firm, such that he could potentially be bankrupt unless he can come to an arrangement with the lending bank. However, all is not lost. He does have access to the potential tax losses and resulting tax repayments.

Often, the tax repayments will be substantial, being for several years, and might, in some instances, fully ?fund repayment of some partner’s partnership capital loans. Ironically, in this scenario, the firm’s bankers will have funded the repayment of the bankers to the individual partners – clearly an unintended consequence.

There are lessons to be learnt from these scenarios in respect of how firms are funded in future. In addition, the recent proposals concerning restriction of reliefs for income tax purposes from 5 April 2013 may also have an impact, encouraging more firms to borrow at the firm level rather than having partners borrowing to inject capital into the firm.

What is clear is that the ?environment for bank funding has changed significantly for firms since the recession and the old practices are being replaced by funders who are starting to recognise the real risks of lending to firms and their partners. Law firms will need to embrace these changes if they are ?to have the continued support of ?their funders.

 

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Key points to consider

• Review existing salaried partner arrangements with a view to what would happen upon the collapse of the firm

• Consider the preference for large capital being provided by the partners personally

• Should the firm’s borrowings and individual partners’ funding be kept separate and with different banks?

• Could partner capital loans be replaced by individual, limited guarantees to the firm’s bankers?

• Could the provision of funding from partners be rearranged to improve the partners’ position in case of the firm’s collapse??

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Colin Ives is a partner and head of professional services tax at accountancy firm BDO (www.bdo.co.uk)