It is the view of HM Revenue & Customs (HMRC) that many members of Limited Liability Partnerships (LLP’s) are not in fact true partners and, therefore, should be taxed as employees. This situation has been allowed to develop partly as a result of the Limited Liability Partnership Act which deemed members to be self employed for tax purposes. It is clearly HMRC’s desire to change the status of these individuals for tax purposes and the consultation over the summer of 2013 was really just a study of how this should be done.
The net effect of failing the test (which is outlined below) is that the individual concerned is brought within PAYE and Class 1 National Insurance is due on earnings, which have previously been taxed as a profit share. There may also be consequences for members of LLP’s previously provided with company cars, as these will now be taxed as a benefit in kind. The ‘profit share’ will be treated as a salary payment for the LLP and will therefore be a deduction in arriving at the taxable profits of the entity.
The proposed legislation will deem an individual (M) to be an employee of the LLP rather than a member of the partnership. It should be noted that M will have no employment rights as he is not an employee for employment law purposes. The deeming rule will apply when M meets all three of the following conditions:
Condition A: there are arrangements in place as a result of which M is to perform services for the LLP in his capacity as a member of the partnership, and it is reasonable to expect that the amounts payable to the LLP in respect of M’s services will be wholly or substantially ‘disguised salary’. This is an amount which is either:
- if it is variable, it is varied without reference to the overall profits or losses of the LLP, or
- is not, in practice, affected by the overall amount of those profits or losses.
Condition B: the mutual rights and duties of the members of the LLP, and of the partnership and its members do not give M significant influence over the affairs of the partnership.
Condition C: M’s contribution to the LLP (his investment or capital at risk) is less than 25% of the total amount of disguised salary, which it is reasonable to expect will be payable in the relevant tax year by the LLP, in respect of M’s performance of services as a member of the LLP.
All three of conditions A to C must be met to trigger the PAYE rules, so if any one of them is not met then M remains taxed as if he were a self employed member of the partnership.
HMRC has provided detailed guidance about how the rules will apply, together with extensive examples of the tests in a variety of situations. This was updated on 21 February 2014.
There is an anti avoidance provision which allows HMRC to ignore any arrangements whose sole or main purpose is to exclude these provisions from applying to one or more individuals. It is not clear how this aspect of the proposals will be used, but means that advice must be caveated heavily in case actions taken are not effective in altering the tax position.
Assume that a 6 partner LLP has three members who are on a fixed salary of £100,000 each. The following tax implications will arise on the partners as a result of the change. We shall also assume that each of the three has a car with a list price of £25,000 and emissions such that the benefit in kind rate is 22%. Previously, only 50% of the running costs of £5,000 per annum (including fuel) have been allowed for tax purposes. The tax written down value of each is £23,000 and the market value is £18,000.
On salaried partners
Tax charge on profits of £100,000 vs salary of £100,000 is unchanged. There is a cash flow issue, as the salary is received net of tax, but as previously self employed individuals, the tax was paid under self assessment.
There is a new tax charge on the benefit in kind on the car, unless the car is disposed of. The benefit in kind is £5,500 per annum. It is unlikely that the partners will accept free fuel for private motoring, as it is unlikely to be beneficial. There will be a beneficial effect of the LLP bearing the running costs (other than fuel) which were previously a private expense – this will affect the remaining partners as it will reduce their taxable profit.
National insurance contributions
The self employed contributions (2014/15 rates) would be 52 weeks x £2.75 = £143. Class 4 contributions on £100,000 (2014/15 rates) would be £4,215, so the total NIC charge on the partner is £4,358.
Contributions paid by the employee under Class 1 would be £5,232, an increase of £874 per annum.
So, the total additional tax and NIC borne by the salaried partners would be between £3,074 and £4,174, depending on whether the partner falls into the 60% band or not.
On the rest of the firm
The allocation of profits which are now taxed as salary have no tax effect on the remaining partners, as both reduce the remaining profits available to the ‘equity’ partners. However, the NIC charge is significant. Employer NIC on the £100,000 salary is £12,702. In addition, there will be a charge to NIC on the company car benefits of £759 per salaried partner.
If the firm bears the additional costs of the partners being reclassified as employees, the additional costs will be £40,383, although these additional costs will be tax deductible on the firm (or the remaining partners). There will be some savings in additional capital allowances, which will now be available at 100% rather than the business proportion of 50%. The figures are unlikely to be material in relation to the figures quoted above.
It is possible that the remaining partners would seek to mitigate the additional employer NIC costs by reducing the fixed profit share still further, so that the net cost is the same as the previous deduction for the fixed profit share. This would reduce the fixed profit share to £88,838 (ignoring the effect of the car) leaving the fixed profit share partners £6,697 per annum worse off (net of tax and NIC – assuming the rate of tax is 40%).
Profit Sharing In Mixed Partnerships
This separate measure is intended to deal with partnerships where there is a member not subject to UK income tax (normally a limited company). HMRC is concerned that these structures are being used to avoid tax on a significant scale.
The broad effect of the proposals is that in the majority of cases profits routed through a partnership owned by a member of the partnership will be taxed on the partner concerned rather than the company through which the profits are routed.
The legislation seeks to attribute profits to an individual member of a partnership (whether an LLP or any other type of partnership) where it is considered that those profits have been sheltered in a non-individual member (usually a company, but in fact any member of the partnership that is not an individual, so this would include a trust) for tax purposes. The measure comes into play when there is at least one individual member and one non individual member of a partnership who have both been allocated a share of the profit in a year. In that case, if either condition X or Y is met, the profits are re-allocated for tax purposes.
It is reasonable to suppose that amounts representing A’s deferred profit are included in B’s profit share, and in consequence, A’s profit share and the tax that would otherwise be payable in respect of both A and B’s profit share are lower than they would otherwise have been. Deferred profit means any remuneration, benefits or returns the provision of which to A has been deferred, whether conditionally or otherwise.
Condition Y applies when the profit allocated to B is regarded as excessive and A can access or gain the benefit of those profits, for example, by being a shareholder in B and drawing them as dividends. If the excess profits are determined as being due to A’s power to benefit from them and there is a consequent tax saving, then the amount of the excess profits are taxed on A.
The determination of whether B has been allocated excess profits allows B to be allocated profits to cover a return on capital equivalent to a commercial rate of interest and a return for any services provided by B to the firm.
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