Partnership Taxation Reforms – Disguised Salary

29 Jan 2014

‘HMRC have ignored profession-wide requests not to apply such a “broad brush” approach which has, as predicted, caught so many genuine partnership businesses using the structures to accumulate profits for internal investment. This now gives the partnership model a very real disadvantage in comparison to the traditional corporate model’ (George Bull, Baker Tilly).

 

We do not agree with George Bull. We will explain why.

Following the 2013 Budget, HMRC published a consultation document on 20 May 2013 entitled “Partnerships: A review of two aspects of the tax rules” (click here for full report), consulting on how to change two aspects of partnership tax rules.

This review focuses on the first aspect, disguised salaries.

The reforms intend to address tax avoidance by Partnerships and LLPs where some Partners/Members are engaged on terms more closely resembling those of employees than real members in the partnership model. The difference is that for employees the business has to pay employers national insurance contributions in of 13.8% of salary whereas for Partners they do not.

The Test

The salaried member test consists of three conditions. If all three are met, the Partner/Member will be treated as an employee.

The areas considered are logical and consider how the person is rewarded (Condition A), how much say they have in the running of the firm (Condition B) how much personal risk they have undertaken (Condition C).

An individual is treated as salaried if:

  • Condition A – The Salaried Member is substantially remunerated through a fixed salary or a variable bonus based on their performance, rather than a share of the profits of the overall business. 
  • Condition B – The Salaried Member does not have a significant say in the running of the business as a whole. 
  • Condition C – The Salaried Member does not have a capital investment in the business of at least 25% of their expected annual income.

The full guidelines on the incoming legislation can be found here.

What do the changes mean?

All Partnerships and LLPs with fixed-share members will have to review their arrangements for these members prior to 6 April 2014 or risk facing an increase in costs of remuneration for such individuals by an uncapped 13.8%.

What can firms do?

Condition A

The drive towards greater performance related pay at large firms has been widespread.
This is invariably based on individual, team or departmental performance and not performance of the business as a whole.
In large firms the individual Partner is so removed from the overall performance of the business that linking their reward to that would not create the desired incentive.
The cost and time required in rewriting the incentive schemes would be prohibitive.

Verdict: Not likely.

Condition B

In any firm of any size it is important to remove Partners/Members from a substantial say in the running of the business, particularly in the more dynamic and competitive market that law firms now face.
Partners/Members are shareholders, not managers and giving them substantial influence here would wreck businesses.

Verdict: Inconceivable

Condition C

Realistically this is the only option open to firms, to increase the capital contributions of fixed share members/partners to an amount which exceeds 25% of their likely annual remuneration.

Verdict: The only realistic option available to most firms.

What are the implications?

Firms have 2 options:

  • Increase their costs by paying 13.8% uncapped National Insurance on the earnings of each fixed share Partner/Member.
  • Increase the capital that fixed share Partners/Members have to contribute

Most will prefer the second option.

That means either firms of partners will have to find banks willing to lend the extra money.

That may not be easy in the current market.

Individual Partners may also see the risk/reward balance as unacceptable. The reality is they are glorified employees anyway but they are now being asked to risk more substantial sums in a business which could fail.

This could be another factor which will dissuade young lawyers from wanting partnership.

Why do we disagree with George Bull?

Historically firms had equity partners and salaried partners.

The reason why they started introducing fixed share partners was to avoid having to pay employers NI. It was tax avoidance pure and simple.

All that is happening now is that very belatedly the revenue is closing the loophole.

The idea that firms are using the savings for internal investment is fanciful. It is going into the profit shares of the equity partners.

The sensible approach for firms is to move to corporate structures so they can retain profit and invest for the future.