Limited liability partnership (LLP) members do not fit comfortably into a partner or an employee straitjacket, and rightly so. This is part of the much-heralded flexibility of the LLP structure which was introduced so successfully over a decade ago.
The proposed tax rules which, from 6 April 2014, will use economic criteria to determine whether LLP members are to be taxed as employees or self-employed, threaten to limit the appeal of LLPs. This comes with the Supreme Court also set to consider the question of rights of LLP members this March.
So why are LLPs being singled out for new tax rules? The answer seems to lie in the fact that HM Revenue & Customs (HMRC) has effectively permitted LLP members to be treated as self-employed, even if they would be considered employees as a matter of general law. This is despite the fact that when LLPs were created in 2000, the policy was to create an entity which enjoyed the limited liability features of a limited company but with the tax consequences similar to a partnership. The established method to determine whether a partner is truly self-employed or an employee requires a careful analysis of the substance of the relationship and case law has developed to assess whether the label 'partner' is in fact merely titular.
There is no real dispute that true employment relationships should be taxed as such. If LLP members are seen to be receiving a tax advantage by avoiding PAYE and employer's national insurance contributions when they would otherwise be seen as employees, the simple remedy would be to evoke the existing case law so that LLP members would be assessed in the tried and tested way.
Unfortunately, HMRC has not taken on board this solution. Instead, in December last year, HMRC announced new tests so that an LLP member will be taxed as an employee if all of the following three conditions are met:
(1) The member performs services for the LLP in return for fixed remuneration or remuneration that is variable other than by the overall profits or losses of the LLP ('disguised salary');
(2) The member does not have significant influence over the affairs of the LLP;
(3) The LLP member's capital contribution to the LLP is less than 25% of the disguised salary expected to be payable for the whole tax year.
To put in another way, an LLP member will be saved from being taxed as an employee if he does not meet one of the conditions above. The focus is on financial conditions (1) and
(3), as in most professional firms the affairs of the LLP are handled by management.
Much has been written about the precious little time afforded to LLPs to review their remuneration structures before the implementation date of 6 April 2014, and also the 'unintended' effect it will have on professional firms. While in theory the economic tests could give LLP members far more certainty as to their taxation status, HMRC's technical note and guidance provided so far leaves many questions unanswered demonstrating that it is difficult, if not impossible, to pigeonhole LLP members.
Further problems with the new tax rules are that they treat LLPs differently from other partnerships. For example, the new rules do not apply to partners in a general partnership which means that, by reason of being a member of an LLP alone, an individual could be taxed as an employee when he would (as a matter of general law) be viewed as a self-employed partner. Further, members of LLPs incorporated abroad (albeit based in the UK) may escape the new tax rules and international firms based in the UK could see members taxed as an employee in the UK but self-employed in other parts of the world. Also, the tax rules do not supplant the general law for determining employment rights.
While being self-employed gives rise to a tax benefit, it comes at the price of less legal rights whether as an employee or worker. In the leading case of Tiffin v Lester Aldridge. a fixed-share LLP member claimed unfair dismissal but the Court of Appeal confirmed that he was not an employee so could not bring this claim.
Another example is the case of Bates van Winkelhof v Clyde & Co. which the Supreme Court will begin to hear on 24 March. At issue is whether Ms van Winklehof, as an LLP member of Clyde & Co, falls with the definition of 'worker' and accordingly has whistleblowing protection. On a day-to-day basis, the employment tribunals will deal with the fall-out from these developments as they apply to LLP members.
It is not objectionable that LLPs can be made up of a mixture of self-employed partners or employees, even though a comprehensive set of rules to determine the employment status of an LLP member is elusive. However, it would be disappointing if HMRC's attempt to establish a new set of tax rules dissipates the attraction of LLPs by singling out its members for different treatment.
Alan Watts (pictured above) is a partner and Hayley Evans is of counsel in Herbert Smith Freehills' partnerships and LLPs group.