More members of limited liability partnerships could soon be taxed as employees rather than as genuine partners, pushing up their income tax bills and, crucially, exposing their firms to employer National Insurance, after HM Revenue and Customs secured a decisive win at the Supreme Court.
The long-awaited judgment in the BlueCrest Capital Management case has landed and, as widely expected across the tax profession, it has gone HMRC’s way. The decision opens the door for the taxman to treat a far wider pool of LLP members as employees, and it lands at a moment when payroll taxes are already a running sore for British business.
Sean Drury, head of tax at audit, tax and business advisory firm Blick Rothenberg, said the ruling was significant well beyond the hedge fund at the centre of it. “This opens the way for more limited liability partnership members to be treated as employees instead of true partners of the business, leading to an increased income tax and National Insurance burden,” he said.
The salaried members rules, introduced by the Finance Act 2014, set three tests, Conditions A, B and C, that determine whether an LLP member is taxed as a self-employed partner or as an employee. The Supreme Court trained its attention on the first two, and in doing so tightened the definitions considerably.
Condition A is the “disguised salary” test. As Drury explained, “If 80 per cent or more of a member’s pay is a fixed monthly salary or a bonus, or linked to personal and divisional performance rather than the overall profit of the LLP, HMRC deems this a disguised salary and therefore that this person should be taxed as an employee.”
Condition B turns on “significant influence”. A partner in a traditional partnership is integral to the business and has a genuine say in how it is run. Someone who merely works within it does not. “Therefore this person should be treated as an employee for tax purposes,” Drury said. Currently, partners are usually taxed as self-employed individuals, so the reclassification is far from academic.
The headline for most firms will not be income tax but National Insurance. Employers now face a 15 per cent employer NIC charge, and applying that to reclassified members’ remuneration is, in Drury’s words, “a significant win for HMRC”.
It may also prove to be the thin end of the wedge. “It may lay a path towards the general application of National Insurance to LLPs, as was widely speculated before the last Budget,” Drury said. That speculation has only intensified as the Treasury leans ever harder on payroll taxes, with employers already shouldering a record National Insurance bill following the rate rise and threshold cut.
LLP structures are commonplace across the professional and financial services sector, from law firms and accountancy practices to asset managers. That is precisely why the reach of this judgment matters.
“The implications of this judgment, not least in HMRC compliance activity, will be significant, and structures which relied on Condition A or Condition B alone will need to review and probably restructure to comply,” Drury warned. Firms that built their partner arrangements around passing just one of the two tests may now find that cushion has gone.
Condition C, which concerns a partner’s contribution to partnership capital, was not addressed by the Supreme Court because it was not relevant to the appeal. Drury expects it to move squarely into HMRC’s sights next. “Capital contributions will need to be genuine contributions of capital at the economic risk of the partner and meet the minimum 25 per cent of expected disguised salary rule,” he said, adding that arrangements underpinned by loans should expect particular scrutiny.
For firms weighing up whether to operate as a partnership, LLP or limited company, the calculus has shifted. Larger LLPs in particular are likely to find that Conditions A and B are now harder to satisfy for their current members, and Drury believes further litigation is a real prospect. “We may see a ‘BlueCrest 2’ appear at the First-tier Tribunal shortly,” he said.
The practical message is to act before HMRC does. With the taxman already sharpening its focus on aggressive planning, partnerships that have leaned on a single condition would be wise to review their member arrangements, capital contributions and profit-sharing mechanics now, rather than wait for a compliance letter to force the issue.