Focus on the positive – new tax changes for law firms could be beneficial

The government’s proposals on taxing non-equity partners in LLPs has largely received negative press. No surprise there – re-classifying fixed, and perhaps even full, equity partners as employees will add considerably to a firm’s national insurance costs. But there is a bigger picture to consider.

The gearing of law firms is a problem. The Solicitors Regulation Authority (SRA) has long been aware that firms need to achieve greater financial stability and has issued many statements to this effect. The introduction of alternative business structures, and the resultant influx of new entrants to the legal services market, has brought the problem to the fore. Many law firms are struggling to compete against better-capitalised rivals.

However, the government’s new tax legislation may be a source of unexpected help. Under the new rules, a partner in an LLP can avoid being deemed as employed if their capital contribution is more than 25% of their expected profit share. So in the months leading up to April when the new legislation takes effect, many partners will protect their self-employed status by injecting capital into the LLP. This will immediately give firms a more robust capital base, a stronger balance sheet and improved working capital.

It could also lead to greater engagement as fixed-share equity partners who suddenly have capital at risk will be more motivated for their practice to succeed. The law firms that went early with capital calls in 2008-09 have been better positioned to ride out the recession.

The legal sector has a poor record for retaining capital – surplus funds are generally withdrawn as quickly as possible – so much will depend on how LLPs use their windfall. The new regime could mark a turning point where partners’ capital is matched against long-term assets. Or better still, investment in technology to improve efficiency. On the other hand, short-sighted personal benefit may prevail and the windfall will simply result in other partners’ current accounts being repaid quicker.

Well-managed firms will seize the opportunity. They will invest in long-term projects and efficiencies. After all those partners providing capital are trusting the management board with their cash.

In addition, the tax changes may further improve law firm finances by encouraging a more prudent approach to drawings. Another way to avoid employed status is by linking remuneration with profits. So LLPs that cannot meet the capitalisation requirement may decide to protect their partners’ self-employed status by adopting a remuneration scheme based on profitability. This would mean imposing strict rules regarding drawings throughout the year, which would improve working capital and cash flow, especially at the pinch points of tax and VAT payment dates. By chance, this is another of the SRA’s concerns regarding financial stability.

I very much doubt that those drafting legislation at HMRC were thinking of good practice and the SRA’s concerns about financial stability. But in a strange way they could end up being remarkably complementary.

Comments written by Peter Noyce – Partner.

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