Under the current tax rules, all members of an LLP are automatically treated as self-employed for tax purposes, including those who only take substantially ‘fixed salary’.  This means that they pay tax on their LLP profit share through the self-assessment system and do not suffer tax/NIC under PAYE. Similarly, the 13.8% employers’ NIC cost is avoided.

HMRC now consider that this treatment has been far too generous since, in substance, the status of many fixed salaried partners is more akin to acting as an employee.  Thus, from 6 April 2014, specific new legislation will apply to treat the majority of ‘salaried’ partners as having an ‘employee’ status for tax purposes.

These rules apply to any LLP partner where all the following three conditions are satisfied:

  • Condition A – The partner’s reward is wholly or substantially (taking to mean 80% or more) a ‘disguised salary’ – i.e. remuneration that is fixed or is variable by reference to individual performance targets.  A profit share that varies by reference to the firm’s profits as a whole would not be treated as part of a ‘disguised salary’ arrangement.
  • Condition B – The partner does not have significant influence over the LLP’s business.  There is no definition of what a ‘significant influence’ means, which creates a great deal of uncertainty with the application of this test.
  • Condition C – Less than 25% of the partner’s expected ‘disguised salary’ for the relevant tax year is contributed as capital.  This condition has to be reconsidered any time there is a change in the partner’s capital contribution or other change in circumstances.  Given this is a reasonably objective test, firms should be able to take their vulnerable ‘fixed share’ partners outside these rules by increasing their capital contribution requirement.

Where partners fall within the ‘disguised salary’ rules for LLPs, their earnings will be subject to PAYE and employees’/employer’s NICs.  Furthermore, they will also be within the ambit of the employment-related securities and disguised remuneration legislation.

Partners in an ordinary partnership (as opposed to an LLP) are not caught by the ‘disguised salary’ regime. The question of whether they are acting as genuine partners or working as employees will still be decided on the precise facts of each case.

Peter Rayney
11 February 2014


In recent years, we have seen the growing use of so-called ‘hybrid’ partnership/LLP structures.  These ‘hybrids’ typically comprise a mixture of individual and corporate partners/members (for simplicity, LLP members will also be referred to as partners).

Although the use of ‘hybrids’ can sometimes be justified on a commercial or legal basis, they are often driven by tax planning motives.  Significant tax savings can be obtained by allocating a sizeable share of the firm’s profits to one or more of its corporate partners (which are, in turn, owned by the individual partners).  Such profits can then be retained at low corporate tax rates and thus sheltered from high income tax rates.

It is not surprising that hybrids have attracted HMRC’s attention.  This has resulted in a series of measures to counter the perceived abuse in this area.  One important change is HMRC’s new ability to re-allocate all or some of a corporate partner’s share of profits to the relevant individual partners, thus subjecting them to higher rates of income tax.

HMRC’s power to reallocate profits to individual partners

Under the Finance Bill 2014 rules, HMRC can trigger a reallocation of profits where there is no commercial justification for the profit sharing ratios.  The rules only apply to accounting periods starting after 5 April 2014, although there are anti-forestalling rules could be triggered for planning undertaken from 5 December 2014.

Specifically, HMRC can re-allocate an ‘excessive’ profit share to the individual partner(s) under new s805C, Income Tax (Trading and Other Income) Act (ITTOIA) Act 2005 where the following conditions apply:

  • The corporate partner’s profit share exceeds an ‘appropriate notional profit’.  This is tested by considering whether the corporate partner’s profits represents an ‘appropriate’ return on:

    –     the capital/assets it has contributed to the partnership/LLP and/or
    –     the services it provides to the partnership/LLP

    In HMRC’s view, the return on capital should not exceed an amount that is economically equivalent to interest.  It also seems that HMRC anticipate that services should be charged on a modest mark-up on cost, but this position is arguable where the company is providing highly skilled services.

  • The individual partner has the ‘power to enjoy’ the corporate partner’s profits.  An individual partner is deemed to have the power to enjoy those profits where they are ‘connected’ with the corporate partner (which includes having control of the corporate partner, including shares held by close relatives).
  • It is reasonable to suppose that the individual partner’s share of the profits is lower than it would have been had the relevant individual been unable to ‘enjoy’ the profits allocated to the corporate partner.

Note that HMRC can also re-allocate an individual partner’s allocated trading/property business losses and capital losses where these should have been allocated to a corporate partner, where the main purpose of the arrangements is to enable the individual to take the tax benefit of those losses.

Anti-avoidance rule for ‘non-partners’

HMRC has anticipated the potential for avoiding statutory re-allocation of profit rules by removing ‘individual’ partners; for example, the ownership of an existing partnership or LLP could be altered to consist solely of corporate partners.

A new s805D, ITTOIA 2005 frustrates such planning because HMRC will be able to re-allocate profits to individuals who are not partners if they have the power to enjoy those profits and would have been a partner were it not for the introduction of this legislation.

Based on the wording of the legislation, there is a decent argument that partnerships/LLPs existing before 5 December 2013 which consist solely of corporate partners should not be caught by these rules, but will HMRC still seek to challenge them?

Compensation adjustments will be made to a corporate partner’s taxable profits to reflect any successful reallocation of profits by HMRC.  Provided the relevant conditions in s850E are satisfied, it should be possible for the relevant individual partner(s) to obtain the funds to pay their increased personal tax liability without adverse tax effects.

Pre-emptive action

Hybrid partnerships and LLPs wishing to avoid the uncertainties of penal taxation under the new rules should consider appropriate restructuring.  This might include moving to a full incorporation of the business or perhaps removing corporate partners and establishing a company owned by the partnership instead.

Peter Rayney
10 February 2014