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New LLP Tax Rules

08 April 2014

Under current legislation, Limited Liability Partnerships (LLPs) are regarded as ‘transparent’ entities for tax purposes, meaning the members (or partners) are taxed as if they were self employed. This has resulted in many LLPs promoting their employees to member status to avoid employers’ national insurance costs on their salaries and benefits in kind (such as company cars). However, new rules have been introduced from 6 April 2014 to close this tax planning opportunity.

LLP members whom HMRC consider are not true risk taking partners will now be classified as ‘salaried members’ and taxed under the PAYE regulations and benefit in kind rules as if they were employees.

The new rules apply a 3 part test to determine whether a member should be a ‘salaried member’. All 3 tests must apply otherwise the member can continue to enjoy self employment status. The tests are:

1) Variable Profit Share

A member will be a salaried partner if more than 80% of the member’s profit share from the LLP has characteristics of “disguised salary” – eg they get regular fixed payments that don’t vary in line with profits.

It is common for new members to be guaranteed a minimum profit share for the first couple of years as an inducement to join. HMRC have confirmed that this type of arrangement will not be disguised remuneration, provided the minimum profit share is only for the first few years.

The test is applied at the later of the date the member first joins the LLP or 6 April 2014 and is only revisited if there is a change in circumstances.

The test looks at expected profit allocations and is not applied with the benefit of hindsight. The test does however apply to the profit share that the member can ‘reasonably expect’, so unrealistic rewards and events that are unlikely to be triggered are ignored.

2) Influence in the Business

A member will be a salaried member if they have no significant influence over the affairs of the LLP. The influence has to be over the LLP as a whole, not just a particular department.

Many members of large LLPs will fall foul of this condition as, in reality, most large LLPs are run by a management board. The member may have some voting rights but no real influence to control matters.

Again this condition will apply from the later of the date the member joins the LLP and 6 April 2014 and will not be revisited unless there is a change in circumstances.

3) Capital Contribution

A member will be a salaried member if the member’s capital stake in the business is less than 25% of their expected profit share.

This test will again be applied from the later of the date the partner joined the LLP and 6 April 2014. However, this test is revisited at the beginning of each tax year. (There is a ‘period of grace,’ until 5 July 2014, to enable existing members to make their capital contributions, provided there is an unconditional requirement to make the contribution.)

The capital stake includes the capital contribution the partner was required to make when joining the LLP in line with the partnership agreement, long term loans made to the LLP and undrawn profits to the extent that they have been converted into capital. It is worth noting however that where a member is intentionally allowed to run an overdrawn current account in order to fund fixed capital this could be caught by anti-avoidance legislation.

If the member is a ‘salaried partner’ the member will cease to be self employed and will no longer be included in the LLP tax return. As this represents a cessation, there may be an opportunity for the member to claim overlap relief from their self employment profits in that year. The LLP will be entitled to a deduction from its trading profits for the ‘salary’ and employers national insurance paid to the salaried member.

The salaried members will however remain partners of the LLP for all non tax purposes.

Obviously LLPs will need to review their profit sharing arrangements to ascertain how these changes affect them and if any changes can be made to fall outside at least one of the 3 tests.

The most obvious route to ensuring a member falls out of the rules is to break test 3 and ensure that a capital contribution of more than 25% of expected profit share is made. However this could require a great deal of cash funds which may not be an option for smaller businesses. Instead test 2 may provide a better opportunity for smaller businesses to break the tests. LLPs may therefore wish to review their partnership agreements and consider if any amendments are required to ensure all members have significant influence over the partnership’s affairs.

Another change in the LLP rules being brought in from April 2014 is the introduction of legislation that will enable HMRC to unravel the allocation of profits between individuals and corporate members. This applies to ‘mixed partnerships’ where the members of the LLP include both individuals and companies. The rules will only apply where the original intention of the profit allocation was to secure a tax advantage. In particular, HMRC will be watching for instances where profits are allocated to corporate members to shelter profits at lower rates of tax.

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