Fund Managers will already be familiar with the salaried member rules which are, as stated in a recent First Tier Tribunal decision involving one Manager LLP:
“…. intended to apply to those members of LLPs who are more like employees than partners in a traditional partnership. They are designed to ensure that LLP members who are, in effect, providing services on terms similar to employment are treated as employees for tax purposes”.
In our experience, most Fund Managers are genuine partners because they fall out of either:
- Condition A – that more than 80% of the member’s remuneration is disguised salary; or
- Condition B – that the member does not have significant influence over the affairs of the LLP.
To be a disguised employee an individual must meet conditions A, B and C (that the member’s capital contribution is less than 25% of the disguised salary). So, if you fail one condition, then you are not a disguised employee.
In the case mentioned above, condition C was met, but conditions A and B were the subject of debate. The First Tier Tribunal decided that all members met condition A, but some had significant influence (failing condition B).
Whilst the outcome was favorable in part to the Fund Manager, it does show how the application of these rules can be scrutinised. When you combine this extra layer of complexity with other tax and regulatory requirements, e.g. the challenges that basis period reform may present for certain LLP members, and the Investment Firm Prudential Regime; it highlights further the debate on whether LLPs are the most appropriate choice of vehicle.
Condition A
Looking at the case, with regards to Condition A, the Tribunal decided that none of the members failed this condition. The members were entitled to a priority profit distribution and discretionary allocations. There were also allocations based on a points system, but it was agreed that these allocations were not disguised salary. Both parties also agreed that the priority profit distributions were disguised salary.
The question, therefore, was whether discretionary allocations were disguised salary.
For it to be disguised salary, it would need to be:
- fixed (e.g., the guaranteed priority profit distributions); or
- variable, but varied without reference to the overall amount of the profits or losses of the limited liability partnership; or
- not, in practice, affected by the overall amount of those profits or losses.
The Tribunal decided that whilst a member’s discretionary allocation may increase or decrease if the profits of the LLP increased or decreased, it did not amount to a concrete link between the discretionary allocations and the overall profits of the LLP. The discretionary allocations were, calculated based upon individual performance. The Tribunal, as mentioned in the following statement, also asserted that the discretionary allocations were no different to the priority profit distributions (which was disguised salary):
“The LLP Agreement provides, at 10.3 (2), that in the event that the profits in any financial year shall not be sufficient to meet those priority allocations in full, and such profits shall be “allocated on a pro-rata basis between the Priority Distributions made to the relevant Members”. In other words, the same thing will happen to the priority distributions as might happen to the discretionary allocations. If there are insufficient overall profits, they will abate. If the appellant accepts that such abatements do not take the priority distributions outside Condition A, then I cannot see why they should do so for the discretionary allocations.”
Therefore, Condition A was met.
Condition B
The debate focused on the impact a member had on the business. HMRC’s view, was that:
“Significant influence is significant managerial influence, and a high earner (or significant biller in the context of a law firm) only wields significant influence if that financial contribution is reflected in “managerial clout”. Furthermore, the inference must be over the overall affairs of the partnership and not just to one or more aspects of them.”
The Tribunal however disagreed, stating that:
“…. the expression “affairs of the partnership” is not restricted to the affairs of the partnership generally but can be over an aspect of the affairs of the partnership. I also agree with her that the starting point for this analysis must be a consideration of what those affairs are; in other words, what does the partnership do.”
Portfolio managers who were members looking after significant portfolios (at least $100 million) were found to have significant influence on the basis that they made a substantial financial impact to the business and were also instrumental in operational decisions such as recruitment and managing relationships. These members were also experienced in the marketplace and trusted at the firm. As such, their role was akin to partners of a traditional partnership who are expected to “find, mind and grind” i.e., to find work, supervise others to undertake and deliver the work and to do the work themselves.
However, for non-portfolio managers, whilst they may have assisted portfolio managers in having significant influence, there was no evidence to suggest that they themselves had a significant impact, like the portfolio managers, on the business activity; and that their roles could be undertaken by an employee in a traditional partnership.
“For example, the head of tax is “Responsible for Tax department including dealing with fiscal authorities around the world and instructing advisers in all jurisdictions. Responsible for agreeing group tax strategy with ExCo”. It is not possible for me to translate this into some form of evidence concerning the influence of that individual over the affairs of the partnership in the sense that he or she contributed significantly to the provision of the back-office services to other members of the Group. The same is true regarding the summaries provided for the other heads of department.”
Accordingly, for the non-portfolio managers, it was decided that they met condition B.
Final thoughts
The case serves as a reminder for all UK LLPs to review their rationale for why they believe members are not disguised employees. We at Centralis Governance, Risk & Compliance can guide you through the salaried member rules.
For new startups in particular, the choice of LLP versus LTD needs to be carefully considered. Bearing in mind that LTD’s facilitate the retention of capital for IFPR purposes, and together with tax simplicity, a LTD may be the better option. However each case is different and where it is clear that individuals fail a salaried member condition (and are therefore genuine partners) then the advantages of an LLP may outweigh tax simplicity. From an IFPR perspective, discretionary remuneration (for genuine partners) does not inflate capital and liquidity requirements in the same way that non discretionary salaries do. So a weighing up exercise of LLP versus LTD is definitely required.