Government Outlines Partnership Crackdown in Finance Bill 2014

Professional services partnerships will have to reconsider their corporate structure following this year’s Autumn Statement and Finance Bill which specifically looks to clamp down on ‘disguised employment’ in Limited Liability Partnerships (LLPs) and the use of corporate members in mixed membership partnerships.

Disguised Employment in LLPs – The Salaried Member Test:

Under current rules, employees classed as partners are automatically presumed to be self-employed. As a result, there are various tax benefits to both the individual and the LLP.

In reality, often these partners are actually aligned much more closely to the role of salaried employees. These junior partners often do not have any of the characteristics of partners, such as equity in the firm, decision making authority and capital risk. The Finance Bill 2014 has defined these junior partners as ‘salaried members’.

Under the Finance Bill’s draft proposals, partners will have to satisfy one of three tests to be able to maintain their status (rather than being classed as salaried members).

The first test considers the manner in which the individual is rewarded for his or her performance of services to the LLP. Under this first test, a partner would have to prove that at least 25% of their pay is profit-dependent.

The second test looks at the capital contribution made to the LLP by the individual. A partner in a traditional partnership risks losing money if the business fails. Under this test, a partner must prove that they contribute at least 25% of their ‘fixed pay’ to the firm’s capital.

The final test examines whether the partner has a significant say in the running of the business as a whole. A partner will have to be able to prove that they have significant influence on the overall partnership. It is this third test that has received the most criticism, with detractors arguing that it is ambiguous and overly subjective.

While there is general support for the government’s ambition to make the distinction between partner and employee clearer, the new rules could make a significant financial difference to junior partners and will force existing LLPs to go through significant restructuring activities.

Tax-motivated allocation of business profits & losses in partnerships:

The second part of the Finance Bill targets ‘mixed membership’ partnerships and particularly the allocation of profits and losses to different members in order to reduce the overall tax burden.

In most cases under scrutiny by the government, partnerships will create 'corporate' (or 'company') members as well as individuals. These corporate members are subject to corporation tax, 23% of profits, whilst individuals are subject to income tax with a top rate of  45% of earnings. Clearly, by diverting profits to corporate members, the overall tax burden is significantly reduced. This has been termed ‘excess profit allocation’.

HMRC believes that in scenarios as outlined above, a high proportion of profits are allocated to corporate members who, in reality, make little or no contribution to the business and in many cases, some or all of the individual partners will own the corporate member and can therefore benefit from the profits allocated to it. As a result, it is very hard for partnerships to justify the use of ‘corporate partners’ for any purpose other than a tax advantage.

Further Information:

For more information about HMRC's clampdown on Partnership arrangements, contact our specialist tax team or complete a quick enquiry form and we will be happy to contact you directly.

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