LLPs – Where Are We Now?

Limited liability partnerships have previously been seen as ‘the best thing since sliced bread’ in tax planning terms, before a HMRC clampdown in recent years. Alan Pink looks at what remains in terms of tax benefits from using them.

For those who are unfamiliar with the concept, an LLP, or limited liability partnership, is a relatively new form of corporate vehicle, which is a kind of hybrid between a limited company and a partnership. 

Like a limited company, it is a body corporate legally, with its own separate legal personality, which can own assets, enter into contracts, and run a business. Like a limited company, it provides limited liability to its members in case the LLP itself runs into financial troubles, and like a company, this is at the cost of having a more prescriptive regime for preparing accounts and lodging annual returns. 

The principle differences between an LLP and a limited company are, firstly, that its capital structure is more fluid, with share capital (usually not given the word ‘share’) being freely introduced and withdrawn without formality; and, all importantly, in its tax treatment. For tax purposes, a legal fiction exists to the effect that the members of the LLP (equivalent to ‘partners’) are carrying on the business of the LLP in partnership. Another way of putting this is that an LLP is ‘tax transparent’ because a partnership, unlike a company, has no existence for tax purposes. The tax treatment of members of an LLP is, therefore, that they are each charged to tax on a fraction of the LLP’s profits and capital gains, like an ordinary partnership. 

Large firms of accountants were very keen for LLPs to be introduced into UK law, lobbying the government for that purpose in the 1990’s. The reasons for this aren’t very difficult to guess. Those who are treated as partners for tax purposes, in a trading or professional business, are treated as self-employed. Therefore, the tax treatment of benefits-in-kind, for example ‘company cars’, tended to be much more benign, and also the National Insurance contributions (NIC) burden on the business was a tiny fraction of the NIC cost of running a business through a company and taking your income out of the company in the form of salaries or wages. 

Very importantly for professional firms, it’s also much easier to admit new members into the equity of a business where the business is set up as a partnership. This is because individuals being given shares in a limited company are taxable on any difference between the value of the shares they get and what they pay for those shares. A young professional, moving up from employee status to status as a part-owner of the business is very unlikely, in practice, to have any substantial amount of money to buy his way in. So, you have an immediate tax problem derived from the ‘employment related securities’ rules (in ITEPA 2003). The problem takes the form of an income tax charge on the value (or undervalue if any amount is actually paid for the shares) together with a Class 1A NIC charge, payable by the employer company, on the value of the shares acquired. 

This is a problem, not just because of the fact that there is a tax liability, but also because of the fact that it is very difficult to determine, in advance of doing the transaction, what that tax liability will be. HMRC’s Shares & Assets Valuation Division can have some quite strange ideas as to the value of what is usually a minority interest in an unquoted trading company!

LLPs, by contrast, are not subject to this difficulty, as generally speaking no tax is charged on a person becoming a self-employed partner in a business, on the value of the business share acquired. 

Tax advisers (in some cases anyway) were quick to see the potential advantages of combining the limited company and the LLP structure, effectively, in one. This is done by introducing a limited company, normally controlled by the individual partners, into membership of the LLP. By this method, any amount of profits which were to be retained in the business (or paid out in some kind of capital form) could be attributed to the limited company member, where they would pay the much lower corporate rates of tax. For example, at the current time, profits attributed to individual partners can bear rates of tax plus NIC of 47%: whereas profits attributed to a company partner are only chargeable at the corporate rate, which is currently 19%. 

So, individuals could have the ‘best of both worlds’, in the substantial NIC benefits of self-employment being combined with the benefit of the low corporate rate of tax on non-distributed profits. 

This was particularly advantageous where there were a lot of senior individuals involved in the business, to whom it was appropriate, because of their likely permanency, to offer some kind of ‘non-equity’ or ‘salaried’ partnership in the LLP. HMRC’s stated view was that any LLP member was, by definition, to be treated as self-employed – so the business itself saved the 13.8% employer’s National Insurance levy on their earnings. This could make a huge difference, and many businesses were restructured as LLPs for this reason. 

At last, in late 2012, there came an announcement, like a cloud no bigger than a man’s hand, that HMRC were ‘reviewing’ the taxation of partnerships and LLPs. These took the form of a number of attacks on the use of LLPs for tax planning, most particularly in the Finance Act 2014. 

This Finance Act attacked two elements of LLP tax planning, which were seen by HMRC as being particularly objectionable: 

The first of these attacks took the form of limiting the amount that you are allowed to attribute to the company member, where the individual members alongside it have the ‘power to enjoy’ profits attributed to the company. From 6 April 2014 onwards, companies can only effectively receive an allocation which is justified by reason of their actual contribution to the LLP’s business. So, for example, a company which was a mere passive recipient of profits was unlikely to be able to justify much of a profit allocation. 

The other main attack was on ‘non-equity’ or ‘salaried’ partners. These are to be treated as employees for tax purposes from 6 April 2014, unless they either have capital invested in the LLP equal to 25% of their expected annual income; or have a variable element of profit share which is likely to be at least 20% of their total income; or, if under the constitution of the LLP, they are able to exert a ‘significant influence’ over the way the LLP is run. 

A lot of people seem to conclude that the Finance Act 2014 changes were effectively the death warrant of LLPs as a tax-efficient business vehicle. I beg to differ. 

Let’s take the allocation of profits to a company in a ‘hybrid’ LLP first. The rules don’t actually prohibit the allocation of profits to such a company, but they do impose a requirement that the allocation be commercial. 

What you can’t do is allocate a profit to the company and justify it by reason of what the company does for the LLP in the way of provision of its director services – where those directors are the same people as the individual members of the LLP, as is so often the case. However, you can justify it by reason of other services provided by the company, for example, office services or the services of non-related individuals who are employed by the company. 

You can also justify a profit allocation to the company by reason of the amount of capital the company has invested in the LLP. What you have to do here, under the Finance Act 2014 rules, is assess what an unconnected person would be paid by way of interest on a loan of an equivalent amount. HMRC appear to think that 2% is a reasonable rate in some cases, but this is clearly unrealistic. In some cases I know about, a 10% return on capital has been successfully argued for. So hybrid LLPs are still with us, even if a little bit battered by the 2014 changes.

A similar picture exists with regard to saving employer’s NIC, and so on, by widening the LLP membership base. Most often, in practice, the continued treatment of non-equity members as self-employed is justified by the fact that they do indeed exert significant influence over the way the LLP is run – the third of the above list of qualifying criteria. So particularly in businesses which are heavily dependent on a lot of very senior input, this can still act as a highly tax (or rather NIC) efficient way of structuring your business.