A tax cloud with a silver lining?

Michael Simmons says planned tax changes for the legal profession will pose problems but will also present opportunities. Michael Simmons is a partner at Finers.

The Inland Revenue's insistence on equal tax treatment of professional partnerships with corporate business ignores certain realities. The search for a level playing field could have damaging consequences.

Every system has built-in checks and balances. The corporate director pays tax on direct income and dividends but profits retained in the business are taxed at lower rates. They enjoy a pension regime and can benefit from share options. If sales are timed correctly, retirement relief will mitigate the effects of Capital Gains Tax.

The professional in partnership pays tax on profit share, whether or not they receive it, provides their own pension out of that profit share and rarely has anything saleable on retirement, so tax relief at that stage is meaningless.

To redress the balance, the lost preceding year basis, when profits were going up, provided a tax deferment. When profits were going down, it could have the opposite effect if a prudent tax reserve had not been maintained. Current year assessment has already taken that advantage away.

The profession is now to be faced with the added expense of a full audit, which will require it to show a 'true and fair' picture in its accounts. This means the end of the cash basis of accounting where debtors and work-in-progress could be conveniently overlooked. But why should lawyers pay tax on what they do not have? The solution is to become like incorporated business.

The 'bills delivered' basis will also be swept away. Here, tax is paid on debtors but not on work-in-progress. Even when lawyers were taxed on a full earnings basis, there were any number of ways of treating work-in-progress. In particular, it was the convention that equity partners' own work-in-progress was not included in the calculation for taxation.

This convention may well be retained in the new regime. It benefits the partner-heavy firm, but penalises the well-geared practice with more non-partner fee earners. Liability to tax increasingly becomes a lottery.

One does not hear that the Inland Revenue is to allow the tax advantages of incorporated business for the un-incorporated professional. This could lead to a rush to incorporation. The proposed Limited Liability Partnership may therefore turn out to be a historic curiosity only. Presumably, advantage will be taken of limited liability on incorporation, even if accounts have to be filed.

Recording work-in-progress is not the problem. The proportion of work-in-progress by firms varies enormously depending on the type of work and the efficiency of the practice. Most have long grasped the principle that it is sensible to convert work-in-progress into cash as quickly as possible.

However, there are many inhibitions. Lawyers practising in the legal aid field have a very tardy paymaster in the Government. Of necessity, work-in-progress and debtors are disproportionately high. Such firms will be penalised heavily on the tax front for matters outside their control. And with the proposed conditional fee arrangements there is little chance of collecting costs until the very end. Ever larger sums of work-in-progress will be built up on a greater number of files. The profession is caught between a rock and a hard place.

At present the Bar, which draws up its accounts on the cash basis, can live on credit and not be over-zealous in pursuing solicitors for payment. Solicitors naturally resent being pressed for payment by the Bar especially when they have not been paid themselves by the client. With the advent of a full earnings basis for barristers that tolerance will end. Barristers' clerks will be pressing assiduously for payment of fee notes.

The old balance will be destroyed. It is likely that solicitors will press the Law Society to lobby for change, so that barristers must look direct to the client or the legal aid fund as paymaster. If the normal rules of agency apply, the solicitor will become the middle man without responsibility for barristers' fees.

This will remove yet one further distinction between the two branches of the profession. It will certainly destroy the delicate economic balance which exists between clients who pay the bills, solicitors as the oppressed intermediaries, and barristers who up to now have had a rather relaxed agenda.

As far as incorporation for solicitors is concerned, one of the main disadvantages cited has been the 'bunching' effect for taxation on conversion of a partnership to a limited company. The new audit provisions for partnerships with the knock-on effect of taxation of work-in-progress and also debtors for those on the cash basis, will have the same effect, or a similar, effect.

Increased National Insurance payments when partners become employees will also have to be factored into the equation. If this happens, expect a mass movement to incorporation, which will create a brave new world of share options, wider share ownership and share ownership by non-lawyers and ultimate flotation of law firms. Goodwill has for many years been a thing of the past for most solicitors. This may give the opportunity once again to cash in on that elusive commodity.

A parallel can be found in the US in the medical profession where financial entrepreneurs are buying up groups of practices. They float these and reward the previous proprietors with shares, cash or a combination of the two. The quid pro quo is that the former independent professionals take on employee status in the new organisations.

Another advantage of incorporation for the smaller practice is that of gaining small company status with freedom from the rigours of audit (hence a reduction in expense), coupled with a lower tax rate on profits retained in the practice. This contrasts with the new requirements for professional partnerships, which seek a full audit for office as well as client account irrespective of size.

The new assault by the Inland Revenue, although at first sight likely to be damaging to the profession, may yet contain some kind of silver lining.