The introduction of this legislation was generally driven by the belief that fixed share partners did not have the same exposure to the risk of fluctuating income or invested capital within the partnership as their full equity counterparts and were, in reality, employees of the firm, and should not therefore benefit from the same tax advantages as equity partners by being taxed on a self-employed basis.
It was also felt that there was an inconsistency with traditional partnerships because it was possible for LLP’s to make its employee’s members for the sole purpose of avoiding the additional cost of Employer’s National Insurance, which currently stands at 13.8%.
The rules dictate that if a member of an LLP meets all of the following 3 conditions, they will be deemed to have a disguised employment and therefore the entirety of their remuneration package would be subject to PAYE. These conditions should be looked at prospectively at the start of each financial year and reviewed on the introduction of any new members. It is one of the rare occasions where failure is the preferred option!
Condition A – At least 80% of the amounts payable by the LLP to the member is ‘disguised salary’
In essence, Condition A will be met if it is reasonable to expect that at least 80% of the remuneration received consists of fixed payments or are not generally affected by the profits or losses of the LLP as a whole.
This does not include performance related bonuses based on the performance of the individual member or on a section or department of the LLP.
Clearly “fixed share” members are at likely of meet this condition.
Condition B – The member does not have significant influence over the affairs of the LLP as a whole
For large LLP’s, only members of the management board are likely to be deemed to have ‘failed’ this condition, whereas HMRC are likely to accept that all members of a small family run business will have significant influence.
Again, fixed share members are likely to meet this test, as those are the members least likely to be involved in making key decisions about the management of the LLP.
Condition C – The member’s capital contribution is less than 25% of their disguised salary
If a member risks losing capital equivalent to at least 25% of their disguised salary should the business be unsuccessful, they will ‘fail’ condition C and continue to be treated as self-employed. It’s important to remember that undrawn profit shares or tax reserves of members do not constitute capital contributions.
The amount of capital contribution is based on the amount that the individual has invested as capital at that time in accordance with the LLP Agreement.
The capital of the LLP is the amount of money or other property that all the members have contributed in accordance with the LLP agreement, to the permanent endowment of the firm. It is not the same as the assets of the LLP which includes everything with a money value and obviously varies from day to day.
As part of the LLP agreement, the amount of capital contributed cannot be varied by the member alone, any variation has to be by agreement of the members.
In addition to their capital, a member is likely to have what is sometimes called a current account and possible a separate tax reserves account. These accounts reflect the member’s day-to-day balance with the firm reflecting things such as their entitlement to a profit share, tax payments and drawings. The current account balance is not capital contributed.
In summary, the capital contributed by a member does not take into account:
- sums that the individual may be called upon to pay at some future date;
- undrawn profits unless by agreement they have been converted into capital;
- sums that are held by the LLP for the member, for example, sums held in a taxation account; or
- amounts of capital that are part of arrangements to enable the individual to “avoid” being a Salaried Member where there is no intention that they have permanent effect or otherwise give rise to no economic risk to the member.
Many LLP’s will have complex profit-sharing arrangements based on a wide range of factors, or have members who receive a fixed profit share, so it is important that LLP members have a good understanding of this complicated area of legislation, or risk incurring the cost of expensive Employer’s NIC and possible fines and interest.