Prior to 2014, this tax treatment of LLP members meant that each and every individual member of an LLP was taxed as if they were a partner in a traditional partnership irrespective of whether, in reality, they were engaged by the LLP on terms more akin to those of an employee. The tax treatment of partners in a partnership when compared to the tax treatment of employees is advantageous, particularly for the LLP, for example, PAYE does not apply and employer NICs are not payable.
In 2014, this advantageous tax position came under scrutiny and, on 17 July 2014, the Finance Act 2014 received Royal Assent and inserted new provisions into the Income Tax (Trading and Other Income) Act 2005 (ITTOIA). The aim of these new provisions was to try and ensure that certain individual members of an LLP are treated as employees for tax purposes, thereby circumventing the opportunity for LLPs to avoid PAYE, statutory payments, such as statutory sick pay, maternity pay, paternity pay and adoption pay, and employer NICs. If an individual member should, under the terms of the ITTOIA, be taxed as an employee, rather than a partner, they are described as a ‘Salaried Member’ of the LLP.
It is worth noting that the Salaried Member rules are tax rules and that they are entirely independent to employment law and the employment rights that employees enjoy.
The Salaried Member rules ensure that an individual member of an LLP is treated as an employee for tax purposes if three conditions are met. If any one of the three conditions is not met, the member will not be regarded as a Salaried Member and he will be treated, for income tax purposes, in the same way as a partner in a traditional partnership.
The three conditions are as follows:
Disguised Salary (Condition A)
Condition A is met where it is reasonable to expect (looking forward) that at least 80% of the total amount payable by the LLP for the member’s services to the LLP (in his capacity as a member of the LLP) will be ‘Disguised Salary’.
An amount payable to a member is Disguised Salary if either of the following criteria are met:
- it is fixed
- it is variable, but varied without reference to the overall amount of the profits or losses of the LLP, i.e. aligned to individual performance
- it is not, in practice, affected by the overall profits or losses of the LLP
If and when a Member receives remuneration that is contingent upon and reflects the profits or losses of the LLP, they will not meet Condition A and they will not be regarded as a Salaried Member of the LLP.
As referenced above, remuneration that is varied but not by reference to the performance of the LLP will be Disguised Salary. What, then, happens if a member is rewarded by reference to the performance of an international business of which a UK LLP is one component part? Whether Condition A has been met or not will depend on the individual arrangements between the LLP and the wider corporate group, including the contribution of the UK LLP to the global profit of the business. If, as part of the member’s remuneration, the amount that they receive from the UK LLP varies by reference to its profits, Condition A will not be met and the member will not be regarded as a Salaried Member.
Significant Influence (Condition B)
Condition B is met if the mutual rights and duties of the members of the LLP, and the rights and duties of the LLP and its members, do not give a member significant influence over the affairs of the LLP.
A partnership is defined by reference to the people who carry on a business together with a view of profit and Condition B is intended to draw upon the spirit of this definition.
Looking at the roles that each individual plays in the business of an LLP, an individual member will have significant influence over the LLP if they are the business, rather than merely work for it. An individual who can exert significant influence over the business of an LLP, for example, those who are involved in the strategy and day to day management of the business, or senior members of the firm who can exert significant influence over the business without having much involvement in the day to day management of it, will fail Condition B and will not be regarded as a Salaried Member.
Capital Contribution (Condition C)
Condition C considers the level of capital invested by a member into the LLP and whether they have a genuine financial risk that rests on the success or failure of the business.
Condition C is met if a member’s capital contribution to the LLP is less than 25% of the Disguised Salary expected to be payable by the LLP to that member in the relevant tax year. Where a member contributes a sum equal or more than 25% of their expected Disguised Salary they will fall short of Condition C and will not be regarded as a Salaried Member.
It should be noted, where an international corporate structure is involved, that, in order to fail Condition C, the capital contribution must be made to the UK LLP and not to another entity within the LLP’s international corporate group. This is the position even if the parent entity of the UK LLP is to make a capital contribution on behalf of a member.
The three Conditions set out above are intended to encapsulate what it means to be a partner in a typical partnership. It is only if all 3 conditions are met that an individual member will be treated as a Salaried Member, with the Income Tax and NICs rules applying as they would to an ordinary employee.
Due to LLP’s successes and growth, more and more businesses wish to amend their LLP Agreement in order to incentivise members current and future. This can bring about a delicate balancing exercise for the managing members between wanting to appeal to prospective members while ensuring that the ultimate control of the business remains with its founding members. This leads to a detailed consideration and application of the Salaried Member rules.