Jun 042013

HMRC has published its Consultation Paper on partnerships, which can be found at the GOV.UK website. There are two areas being targeted:

  • Disguised employment – relating to limited liability partnerships or LLPs only. Partners who are in substance employees, will be treated as employees – leading to a potentially higher tax bills for both “employee” and the LLP;
  • Profit and loss allocation schemes – where profits and losses can be shifted between various members of the partnership to minimise the overall tax burden. It is proposed to stop this from happening.

In this article we shall look at the proposed new rules for disguised employment. Profit and loss allocation schemes will be discussed in a later article.

But first – what are LLPs and why is there such a big deal about them?

LLPs are corporate vehicles, just like companies – but unlike companies, they are tax transparent. Hence the name limited liability partnership.

  • The first two words “limited liability” disclose the corporate nature of the creature. The members aren’t likely to lose the roofs over their heads if the venture flounders;
  • The term “partnership” makes clear that no tax is paid at the corporate level, unlike the case with companies. Although the LLP is a distinct legal entity, the earnings of the business are deemed to accrue directly to the members, each member being taxed in accordance with his profit allocation.

So the members have the best of both worlds. Protection from creditors and no tax leakage.

Disguised employment – what are the proposals?

Under the current rules, there is a presumption that individual LLP members are self-employed for tax purposes. This is a favourable outcome as there are no PAYE/NIC deductions to be made from partnership drawings.

HMRC’s concern is that a lot of businesses structured as LLPs have “promoted” their employees to partnership status, in order to take advantage of the more favourable tax treatment. While these people have been designated as partners, or members, they are still, in substance employees – they draw the same fixed salary and have the same perks, but don’t contribute any capital or share in the risks of the business.

In other words, these people are still employees – only the label has changed.

It is now proposed to remove the presumption altogether. There is to be a two-fold test to determine whether each member is really a business owner, or should be treated as an employee. The consequences of being demoted to a salaried member are:

  • Liability to account for income tax and Class 1 national insurance contributions;
  • The LLP will have to pay secondary employer national insurance contributions and also bear the burden of deducting payroll taxes;
  • But the LLP will be able to deduct the employed member’s “salary” as a business expense in the normal way.

What are the proposed tests? Risk and reward

 This is what HMRC is getting at1:

“…individual members of an LLP are taxed as if they are partners even if their membership terms are such that the individual would normally be regarded as being in an employer/employee relationship. For example, members will be taxed as partners even if they have fixed salaries, are not exposed to risk, take no substantive role in the management of the business and have no right to profits or assets if the partnership ends.”

In short, business owners risk their capital in the venture, in the hope of achieving above average returns. Employees are rewarded with a “safe” salary that will always be paid knowing that at the end of the day, if the business collapses, it’s only their job that they’ll lose.

There are two tests:

Condition One – is he really an employee?

This looks at the relationship between the LLP and the member – would this person be normally regarded as an employee under normal tax principles? For example, is he required to attend a fixed set of hours at the office, does he have to be told what to do, does he get paid more for “overtime”?

If all the hallmarks of the relationship point to that of an employee, the tax computations will need to be adjusted accordingly.

Condition Two – is he taking on risk?

 Even if Condition One is surmounted, there is another hurdle. A member who satisfies the following three conditions is treated as an employee:

  • He bears no economic risk if the venture fails – no loss of capital or requirement to repay partnership drawings;
  • He has no entitlement to a share of the profits; and
  • He has no entitlement to a share of any surplus assets on a winding-up.

In other words, we are going back to the question of risk. Is he a business owner, who bears the risks of losing his equity if everything goes under, or is it only his job that he’ll lose?

The risks and rewards must be real, not token.

For example, consider a partner who is paid a guaranteed amount, no matter what happens.

  • There is a bonus clause whereby he gets a 10% uplift if certain profits levels are achieved – this would point to him being a business owner. However, if these profits levels are wildly unrealistic, he’s more likely to be considered an employee;
  • Alternatively there is a clawback element to the guaranteed amount, in the event of the failure of a project he is working on – for example a business deal falling though. This is a real risk. But if the clawback is never likely to happen in practice, he’s an employee;
  • He pays a £100 capital contribution – this is a pitiful amount – he’s still an employee;

Who does this affect?

 The new proposals are aimed at those LLPs with members who neither undergo the risks nor share in the same rewards that one would normally expect of in a business owner.

This is the key point to bear in mind for those businesses that are reviewing their partnership arrangements in preparation for when the new rules are expected to come into force (April 2014). For each individual member, the management team need to ask:

  • What does this person do in the workplace? What are his duties and responsibilities? Is he a business owner or an employee?
  • Do we really want this person as an employee or as “one of us”? If the latter, does the documentation properly reflect this? What does the partnership agreement say about his remuneration? Do the relevant “Board Minutes” or any other documents record that he has participated in management decisions?
  • What shall we do if the evidence shows that he is more likely to be treated as an employee? Do we need to make a provision for unpaid PAYE and national insurance contributions should HMRC come tapping at the door?
  • Alternatively shall we make this person a real “partner”? What extra duties or provisions can we insert into the LLP documents to make sure of this? Are we prepared to share our own equity with this person?

Professional service firms – are fixed share partners affected?

There is one point of comfort for those working in professional partnerships such as law firms or accountancy practices. HMRC has explicitly stated that the new rules are not targeted at fixed share partners2:

“They [the new rules] are also not intended to affect the status of persons who are taken on as members at an appropriate point in their career in recognition of their professional knowledge and personal skills, and who sacrifice an entitlement to salary in exchange for the opportunity to participate in the business in much the same way as a senior partner, even if as junior partners they are substantially rewarded by a fixed profit share.”

This is all very well, but the Consultation Paper doesn’t go on to state how and why fixed share partners fall outside the rules, especially the second condition. Hopefully we will have some more guidance on this in the future.

Closing comments

The timetable is quite a short one. The consultation period ends on 9 August 2013 (when everyone is off to the seaside), and the aim is to have the new rules in place for April 2014.

What would be particularly useful from HMRC is more guidance on the status of fixed share equity partners in professional LLPs. Why and how is it that the second condition doesn’t apply to them?

It would also be useful to know whether there will be any retrospective element in the new legislation. For example, if a person is demoted to employee status, will the liability to account for PAYE and national insurance run from April 2014, or will this be backdated? Hopefully the former – otherwise the consequences may well prove to be too expensive.

In Part Two we shall take a closer look at profit allocation schemes and what HMRC is intending to do about them.


  1.  Consultation Paper paragraph 2.7.
  2.  Consultation Paper paragraph 2.13.
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Satwaki Chanda

Satwaki Chanda

Satwaki Chanda is a tax lawyer with a First Class degree in Mathematics. Called to the Bar in 1992, he is the Editor of Tax Notes.
Satwaki Chanda

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