Quite separately from the provisions on “mixed partnerships” (see here for our briefing), Finance Bill 2013 contains provisions to re-characterise certain members of LLPs as employees for tax purposes. The provisions refer to these as “salaried members” but it is important to appreciate that the rules can apply very much more widely than to what most people would recognise as “salaried members”.
What is the effect of the legislation?
Members of an LLP who are within the scope of the rules will be treated for all tax and NIC purposes as if they were employees, and the LLP will be required to operate PAYE on their profit share as if it were remuneration from an employment with the LLP. In particular, employers’ NIC will be payable in respect of the relevant profit shares.
When do the new rules come in?
The legislation takes effect from 6 April 2014.
Which members are caught?
Any member who performs services for an LLP as a member of it (i.e. a working member as distinct from a passive or investing member) is treated as an employee of the LLP unless one of three tests is met. It is not necessary for all the tests to be met: any one of them is sufficient.
The first test is if the member’s share of profit of the LLP is, at least to a substantial extent, determined by reference to the total profits of the LLP. For this purposes “substantial” is taken by HMRC to be 20% or more. Thus if 80% or less of the expected profit share is fixed (or is determined by reference to personal performance, departmental performance or something other than the LLP’s total profits) and at least 20% of the expected profit share is genuinely related to total LLP profit the test will be met. This (particularly the question whether profit share is genuinely related to total LLP profit) is likely to be the most controversial test.
The second test is if under the LLP agreement and as a question of fact the member has “significant influence” over the affairs of the LLP. HMRC paraphrase this by saying that the test is whether the member “is” the business rather than someone who works for it. In small LLPs where all members actively participate in the business decisions the test is likely to be passed by all members: in larger LLPs where there is a “management committee” it is likely that only members of the management committee will pass the test. The test is a factual one: whether a member is or is not a “designated member” under the Limited Liability Partnership Act does not matter
The third test is if the amount which the member has contributed as capital to the LLP is at least 25% of the part of the profit share which is fixed (or otherwise determined by reference to personal performance, departmental performance or something other than the LLP’s total profits). For this purpose the “capital contribution” does not include undrawn profits (unless they have formally been converted into partnership capital), sums held by the LLP in a taxation reserve account for the member, or amounts which a member is potentially liable to pay at some future date but which have not actually been contributed.
There is a general anti-avoidance clause which seeks to counter arrangements aimed at getting round the new rules. For example if a member’s capital contribution is funded by non-recourse loans made to him by other members so that he bears no real risk of loss, the capital contribution is likely to be disregarded. Similarly, a simple arrangement whereby the working member has a negligible amount of profit share but a related party is introduced as a passive member with a fixed profit share is unlikely to work.
Can these provisions apply to corporate members of an LLP?
Generally, these provisions apply only where an individual is working for the LLP; they do not apply to individuals who do no more than invest money in the LLP; nor do they generally apply to companies. However, the anti-avoidance clause counters the simple interposing of a company between an individual and the LLP. So the replacement now of an individual “salaried member” by a company controlled by the “salaried member” would not get round the rules. It is not clear whether an existing “fixed profit share” corporate member could be caught by the anti-avoidance clause: we think probably not, though it would then be necessary to examine the position under the “mixed partnership” rules referred to above.
What about “eat-what-you-kill” arrangements?
These are particularly common in the financial sector and describe arrangements whereby a member’s share of LLP profit is determined wholly or mainly by reference to the profitability of a sector of the LLP’s business or of a team’s performance. Very often members will not meet the second test above. Some care will be needed to examine existing arrangements and to examine ways of re-structuring them to ensure that if possible the first or the third test is satisfied.
Does this legislation apply to partnerships other than LLPs?
No. For other partnerships (including general partnerships, Limited Partnerships and all foreign law partnerships) the question whether an individual member is properly treated as a partner or as an employee is a matter of law determined by the general tax and employment law in the field. Those tests are quite different from the three statutory tests described above and it is certainly possible that a member of a general partnership would not be treated as an employee even if he would have failed all three tests had the business been carried on through an LLP. However, the new “mixed partnership” rules do apply to all forms of partnership and would be one of the many factors which would need to be taken into account in making any decision to change from an LLP to a general partnership.
Case studies:
A LLP has as its members A, B, C sharing profits equally. They introduce D as a member. D’s share of profits is a fixed amount of £100,000 plus whatever discretionary bonus the other three members decide to allocate. D does not participate in management decisions affecting the LLP. Under the new rules, D will be treated as an employee unless he contributes at least £25,000 of capital to the LLP. It would not matter if some or all of the £25,000 were raised by a commercial bank loan arranged by the LLP; nor would it matter that the LLP were to give an undertaking to the bank that the loan will be repaid directly to the bank out of D’s capital account on D’s leaving the LLP
A member of XYZ LLP is entitled to a profit share equal to 75% of the profits made by the team which he runs, regardless of the profits or losses made by other teams. He has not contributed any significant amount of capital and is not a member of the LLP’s Management Committee. Under the new rules he will be treated as an employee since no part of his profit share is determined or affected by the overall profit of the LLP. He would not be treated as an employee under the new rules if the profit-sharing arrangements were changed such that he was entitled to, for example, 60% of the profits made by the team which he runs plus 5% of the profits made by the LLP as a whole, provided it is reasonable to expect that the 5% share of “whole-firm” profits will account for at least 20% of his total profit share.
HMRC are inviting further comment on the draft legislation and it is expected that a final version of the legislation together with further guidance should be available at some time after 4 February 2014. Meanwhile this page will be kept updated as further guidance and commentary becomes available.