Although legally a member of an LLP cannot simultaneously be its employee, legislation introduced in 2014, known as the salaried members rules, means an LLP member could be taxed as though he or she was an employee if certain conditions are met.
For professional services LLPs, a common way of ensuring that its members were not taxed as employees was to require them to contribute a significant amount of capital to the business.
However, recent changes to HMRC guidance have cast serious doubt on whether HMRC will accept this approach to partner capital contributions. This will be unwelcome to many LLPs with fixed share partners, and may add to firms’ cashflow woes arising from the recent reforms to the basis period.
Nevertheless, the recent decision of the Upper Tribunal in HMRC v BlueCrest Capital Management (UK) LLP, which adopted a more expansive approach to one of the other conditions, may provide some comfort for professional services firms.
What are the criteria required to be taxed as self-employed?
In summary, in order to be taxed as self-employed, the salaried members rules require that an LLP member must have at least one of the following three hallmarks of partnership:
- 20% or more of their remuneration must vary in line with the LLP’s profits (“Condition A”);
- significant influence over the affairs of the LLP (“Condition B”); or
- a capital contribution of greater than 25% of his or her expected fixed profit share (“Condition C”).
However, these conditions are not the end of the story. This is because the legislation includes a “targeted anti-avoidance rule” (“TAAR”) which states that arrangements which have the main purpose, or as one of their main purposes, of securing that the salaried members rules do not apply are to be disregarded.
If an LLP member has none of the three hallmarks of partnership listed above, his or her remuneration will be subject to tax and national insurance contributions (“NICs”) as an employee, meaning:
- income tax and NICs will need to be deducted at source by the LLP and accounted to HMRC in accordance with the PAYE regulations which apply to employees;
- unlike with self-employed members, the LLP will be required to pay employer’s national insurance on the member’s income, at 13.8%; and
- the LLP may suffer penalties for late payment of tax.
UK LLPs are required to assess whether their members should be taxed as employees or as self-employed at the beginning of each tax year on 6 April, as well as upon the occurrence of certain other triggers such as changes in remuneration.
The BlueCrest case demonstrates the high cost of getting the assessment wrong. In that case, HMRC sought to impose on the LLP (with some success, despite the LLP’s appeals the First-Tier Tribunal and latterly to the Upper Tribunal in 2023) a tax and national insurance bill of more than $150 million.
Condition C in the crosshairs
Requiring substantial capital contributions has been a common approach of many LLPs to avoid fixed share partners being taxed as salaried members. This has been achieved by having them contribute not less than 25% of their fixed profit share as capital to the LLP. Of course, this has meant that increases in a member’s fixed share of the LLP’s profit may require him or her to increase the total capital contribution.
There is no grace period to contribute increased capital if an existing member’s remuneration is increased beyond where his or her capital contribution is 25% or more of their remuneration. This is one reason why it was common practice always to require partners to maintain sufficient capital to provide a buffer to account for remuneration increases and to make the contribution of capital a condition to any remuneration increase taking effect.
However, HMRC’s recent updates to the guidance in its Partnership Manual suggests that this approach is likely to be caught by the anti-avoidance provision. It now states the following in the course of giving a worked example:
X contributes a further £10,000 as part of a separate arrangement with the LLP, where members increase their capital contribution periodically in response to their expected disguised salary, in order to avoid meeting Condition C.
This arrangement will trigger the TAAR and no regard can be given to the £10,000 when considering whether X meets Condition C. As such X will meet Condition C as their contributed capital remains at only £15,000.
This amendment to the Partnership Manual ought to be seriously considered by LLPs whose members currently rely on Condition C. Such LLPs should reflect upon how else they might demonstrate that its members fall beyond the scope of the salaried members’ rules. It remains to be seen where HMRC will draw the line between taking the salaried member rules into account and falling foul of the new guidance on the application of the targeted anti-avoidance rule.
Is Condition A the solution?
Members relying on Condition A must, in summary, have less than 80% of their remuneration classed as “disguised salary”.
“Disguised salary” means remuneration which is either fixed or, if it is variable, is varied without reference to the overall amount of the profits of the LLP or is not, in practice, affected by the LLP’s profits.
A common pitfall when assessing disguised salary is to fail to realise that variable remuneration can still be disguised salary unless it is variable by reference to the overall profits of the LLP.
Examples of where this confusion may arise include:
- where members are paid variable bonuses based on personal performance (unless the bonus is a proportion of the LLP’s overall profits); and
- where remuneration is calculated by reference to the turnover of an office, department or of an international grouping (such as many international law firms), rather than the profits of the LLP as a whole. These may be examples of disguised salary, notwithstanding that the amounts in question may vary from year to year.
Given the requirements of Condition A, an equity partner will often not be caught by the salaried members rules, since his or her remuneration varies depending on the overall profitability of the business, but this is not universally the case.
In light of the tightening of the HMRC guidance regarding Condition B, UK LLPs should consider whether they should introduce an additional share of the LLP’s profits for fixed share partners which varies with the overall profits of the LLP, for example in the form of a shadow equity units scheme, or more radically move to an all-equity partnership.
Is Condition B the solution?
LLPs relying on Condition B must ensure that the relevant members have “significant influence” over the affairs of the LLP. To qualify for this condition, HMRC guidance suggests that the member must have power to control the direction of the business, such as appointing new members, moving premises, expanding the scope of the LLP’s business and setting strategy.
A key pitfall for this test is when LLPs confuse management powers with administrative responsibilities. HMRC guidance explains that administrative functions – such as paying invoices, filing accounts and tax returns, dealing with suppliers and handling routine compliance matters – will be unlikely to meet Condition B.
Although members in a small LLP may often be in a position to rely on Condition B, this will not always be the case if (for example) much of the management power is vested in a single member or committee of members, or if the direction of the LLP is largely controlled by a parent entity.
However, the recent decisions in the BlueCrest case took a more expansive view of what constitutes significant influence. In the First-Tier Tribunal, the Judge said:
I can see no justification to restricting significant influence to solely managerial influence. Financial and other influence demonstrated by a partner in a traditional firm colours my interpretation of this Condition… it extends well beyond solely managerial influence, and into the other aspects of a partner’s activities in a traditional partnership…
To my mind, therefore, provided it can be shown that an individual member significantly influences either the investment activities, or the provision of back-office services, (or indeed both) undertaken by the appellant, then the member falls outside Condition B.
The Upper Tribunal has recently upheld this interpretation.
This means even larger LLPs may be able to fall outside of the salaried members rules on the basis of members’ responsibilities within the business.
Practical steps
Once an assessment has been made as to whether a member should be taxed as an employee or self-employed, the LLP should ensure that the basis on which that judgment was reached is appropriately documented.
There are a range of documents that LLPs will have or generate that should support the judgment as to a member’s status. These might include:
- an up-to-date members’ agreement setting out management roles and the basis of partner remuneration;
- financial information, such as profitability targets and forecasts; and
- other records relating to remuneration, such as management or remuneration committee minutes.
LLPs should be ready for their assessment of their members’ tax status to be scrutinised by HMRC at any time. An investigation may be triggered by HMRC reviewing a member’s tax returns, the LLP’s PAYE filings, or HMRC may simply choose to investigate a firm without any clear trigger. LLPs should not just make a judgment about a member’s tax status, but make sure that they record the basis on which that assessment has been made, to evidence the LLP’s expectations.
Contact us
Please get in touch if you require assistance with any aspect of judging whether a member can rely on a condition or how best to record those judgments.
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