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Changes to Partnership Tax Rules Affect Associates Seeking Partnership

Changes to Partnership Tax Rules Affect Associates Seeking Partnership

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Associates aiming for partnership in the near future must be aware of recent tax changes affecting limited liability partnerships (LLPs). New rules mean that lawyers moving into management roles may effectively remain employees for tax purposes despite their elevated status in the firm.

In line with the draft Finance Bill 2014 published last December, new tax anti-avoidance measures targeting LLPs began to apply this fiscal year. Estimated at bringing in approximately £1bn of additional tax revenue, the changes treat certain fixed-salary partners as employees, in turn removing the presumption of the self-employed status of partners.

This does of course have implications for the net income that anyone caught by the rules can expect to take home, which may be something worth remembering in any negotiation— particularly if you are considering moving firms to secure partnership.

How is a Partner’s Employee Status Determined?

Since 6 April 2014, in order to determine that a partner is in law an employee, all of the following conditions need to be met:

  • First, at least 80% of the individual’s remuneration is fixed or fails to relate to the profits of the overall firm;

  • Secondly, the individual member does not have a significant influence over the affairs of the firm;

  • Thirdly, the individual’s capital is less than 25% of their annual salary.

Where a partner is assessed as an employee, they will be subject to PAYE and employees’ National Insurance Contributions (NICs). Additionally, the LLP itself will be liable for employers’ NICs. Employers’ NICs currently stand at 12% of primary class one contributions so these changes represent potentially huge increases in costs for law firms with LLP status— of the top 200 law firms in the UK, 162 are LLPs.

HMRC’s Attack on the Partnership Model

HMRC have argued that, within the self-employed classification of salaried members at law firms, many of these partners are in practice employees who merely earn a share of profits as a tool of retention.

Law firms, their lawyers, and many other businesses operating as partnerships such as financial LLPs took a very different view when the changes were introduced. The popularity of the fixed-share partnership model meant the changes elicited mostly negative responses.

In addition, the relatively short notice for the proposals is likely to have been disruptive to recent partnership promotions. This is due to the costs of implementing organisational changes to mitigate the negative effects on cash flow, profitability and, not least, the incentives for individual partners.

The fact that more tax will now be deducted at source and paid to HMRC every month in the same way as for normal employees also has implications for law firms’ working capital. This is insofar as the LLP would have been partially capitalised by the tax reserves of the fixed-share partners affected by the changes.

What it Means for Ambitious Associates

If you are an associate seeking partnership, you should account for these changes in your prospective career decisions. If you are ultimately seeking the position of full equity partner, the fact that many LLPs utilise the salaried partner role as an effective probationary period should receive even greater acknowledgement in light of these changes.

If firms do seek to exempt junior partners from employee status, many will be providing for those partners to fail the third condition of the employee test noted above. This will require you to inject, in the form of capital, at least 25% of your expected annual earnings. Depending upon your personal circumstances, such a requirement may necessitate financing in the form of a bank loan, for example.