It has been almost half a year since the new rules for "salaried members" of limited liability partnerships ("LLPs") came into effect. This article provides a general refresher on the main conditions of the rules and some observations from practice.
Under the UK tax code, there is a presumption that individual members of an LLP are self-employed for tax purposes, rather than being employees. The key effect of this is that LLPs do not have to account for employer national insurance contributions on amounts paid to individual members who are treated as self-employed.
In response to the perceived abuse of these (and other partnership) rules, HM Revenue & Customs ("HMRC") launched a consultation in May 2013 on changes to prevent LLP members from being taxed as self-employed if they were, ostensibly, employees of the LLP. For historical interest, it is worth noting that the consultation specifically stated that the new rules would not affect persons taken on as members in recognition of professional knowledge and skills, albeit substantially remunerated by a fixed profit share (i.e. fixed share members of professional service firms such as law and accountancy practices).
Many people were surprised then when HMRC published the outcome of the consultation in December 2013, effectively scrapping the salaried member test as originally proposed and introducing a new test which would also apply to fixed share members of professional service firms. As the new salaried member rules were introduced with effect from 6 April 2014 (albeit the legislation was not finalised until the Finance Bill 2014 received Royal Assent on 17 July 2014), firms were given very little time to consider the rules and, if thought necessary, to make changes to avoid members being taxed as employees.
Overview of rules
The new rules only apply to UK LLPs and do not need to be considered by general or limited partnerships (or non-UK LLP equivalents). It is also worth noting that the new rules are only intended to apply for tax purposes – in theory, a member could be treated as an employee for tax purposes but not for employment law purposes.
The legislation sets out three conditions (Conditions A, B and C), all of which have to be met for a member to be treated as a salaried member. As all three conditions have to be met for salaried member status, it follows that a member can escape salaried member status if it fails at least one of the three conditions.
Condition A – disguised salary
Condition A seeks to identify those members that receive a so called "disguised salary" from the LLP, being amounts more akin to an employees’ salary rather than being an actual share in the profits of the LLP. Condition A is met if, broadly, it is reasonable to expect (on a forward looking basis) that at least 80% of the total amount payable to a member over a particular period is disguised salary.
Disguised salary is defined in the legislation as being amounts payable to a member which are:
- variable, but without reference to the overall profitability of the LLP; or
- not, in practice, affected by the LLP’s profitability.
HMRC’s technical note on the rules goes into some considerable detail on what does (and does not) constitute disguised salary. The key underlying question is whether the amount payable to the member varies depending on the overall profits or losses of the LLP. If the answer to this underlying question is "no", then it is likely the amount will be treated as disguised salary.
HMRC stress that variable remuneration can still be disguised salary if it is based on the personal performance of the member, rather than on the overall profits of the LLP. At first glance this may seem problematic for LLPs wanting to remunerate high flying members with increased profit share based on that member’s performance. It is, of course, not contrary to a partnership model that certain partners would expect to receive a greater slice of the cake if they perform better than other partners. However, provided that members are rewarded for their personal performance by an increased share in the LLP’s overall profits, this Condition A would not be met and the profits payable to the member would not be viewed as "disguised salary". Assigning equity points in an LLP based on personal performance would, therefore, avoid the application of these rules.
In contrast, if a member is rewarded with a fixed amount based on their performance, or for example a percentage of their own billings, then any such amount will be treated as a disguised salary as it would not be affected by the overall profits of the LLP.
Condition B – significant influence
Condition B is met for those members that do not have a "significant influence" over the affairs of the LLP. Accordingly, any member that does have a significant influence will fail Condition B and so cannot be taxed as a salaried member.
The legislation itself does not define what is (or is not) a significant influence, so again the HMRC technical note is important in understanding how HMRC intends to apply the rules. Broadly, the test is intended to exclude those members that have a "real say" in the LLP "on the basis of a realistic view of the facts".
In practice, it is unlikely Condition B will have much relevance for professional service and other LLPs that have delegated their management to a committee or particular member (for example, a corporate member established to exercise management functions). If the key management powers have been delegated, then the person (or persons) holding the management powers will fail Condition B, whilst all other members will likely satisfy Condition B. Further, the "realistic view of the facts" application of the test leaves scope for interpretation and as such makes Condition B difficult to apply compared to the other conditions.
Condition B will be of more relevance to smaller LLPs, where members that received a disguised salary also have significant influence over the running of the business.
Condition C – contribution to the LLP
Condition C seeks to exclude those members who have contributed such capital to the LLP as to have a genuine exposure to the success of the business. A member will meet Condition C if their capital contribution to the LLP is less than 25% of their disguised salary (if any). Accordingly, provided an individual member contributes capital equal to at least 25% of their disguised salary, they will fail Condition C and so cannot be taxed as a salaried member.
The mechanical nature of Condition C means that (when compared to Condition B) it is a much clearer condition to "fail" and thereby avoid individual members being taxed as employees. As such, it is expected that LLPs wanting to remunerate their members with fixed amounts, but avoid them being taxed as employees, will seek to fail Condition C through their members introducing sufficient capital to the LLP.
Given that the policy objective of the salaried member rules is to ensure that individuals who are, effectively, employees of an LLP are taxed as employees, Condition C is arguably inconsistent. However, whilst Condition C provides a form of escape route from salaried member status, the intention is that Condition C will only be "failed" if the member is genuinely exposed, through the member's capital contribution, to the success or failure of the LLP.
In this regard, the salaried member rules also contain an anti-avoidance provision which disregards arrangements the main purpose (or one of the main purposes) of which is to avoid salaried member status. The HMRC technical note contains guidance on the interaction between the anti-avoidance provision and arrangements whereby members obtain financing to make a capital contribution to their LLP (which is common in practice). Broadly, provided an individual member incurs a genuine debt to make a genuine capital contribution to the LLP, it appears unlikely that HMRC would seek to apply the anti-avoidance provision. Moreover, the legislation provided a grace period for members to obtain finance to make their capital contributions, provided they had given an undertaking to do so by the time the new legislation became effective.
Although the overall test for salaried member status is whether an individual meets all three conditions, it can be helpful to think of Condition A as the starting point to catch members who are effectively paid as employees, with Conditions B and C being the means to avoid salaried member status (i.e. even if the majority of a member's remuneration is disguised salary, the member would not be taxed as an employee if he or she has significant influence or they have contributed sufficient capital).
In practice, Condition B may be harder to fail and it is expected that those members who do have significant influence will likely derive most of their remuneration through profit share (and so fail Condition A) in any event. Condition C, in comparison, provides a clearer mechanism for members that otherwise meet Conditions A and B to avoid salaried member status, provided that a genuine capital contribution is made by the member.
It is important that all LLPs, whether LLPs in existence at 6 April 2014 and those established in the future, fully consider the salaried member rules to ensure individual members are correctly taxed.