Incorporation may seem attractive, but limited liability has its price, and staying as a partnership can still have its advantages, says Anne Gregory-Jones. Anne Gregory-Jones is a partner at Kidsons Impey.
Making a decision about incorporation is high on many partnerships' agendas. The proposed rules on Jersey Limited Liability Partnerships (LLPs), an increasingly litigious marketplace, and the rising cost of professional indemnity insurance make limited liability appear attractive. But incorporation has pros and cons.
When it comes to savings on professional indemnity insurance, a newly-incorporated firm will in fact probably need to maintain its professional indemnity cover. And protection of limited liability will only assist if the business collapses as a result of a substantial negligence claim. Although it may save the personal assets of the shareholder, the business will be destroyed, along with the directors' credibility.
In a partnership, the partners can take precautions to safeguard their assets, one of which is to transfer personal assets into their spouses' names.
Companies have the advantage when it comes to retention of profits. Unlike partnerships, where full distribution of profits at the end of each year is normally expected, companies can retain profits for the use of the business. As long as the company is successful in the long term, retention of profits in good years may enable the remuneration of the directors to be maintained at a relatively constant level, even when the overall business profits drop.
Companies are currently taxed at a lower rate than individuals. Also, with the introduction of self assessment, one of the principal objections to incorporation has been eliminated. Partnerships are no longer taxed on a prior year basis; they now work on a current year basis. On the prior year basis incorporation would have meant a large tax bill, whereas on the current year basis the impact is significantly reduced.
It is, however, still advantageous to remain as a partnership when it comes to National Insurance. On incorporation, partners become employees, taking salaries rather than profit shares, and liable to class one National Insurance contributions rather than class two and four. The company will also be liable to pay employer's National Insurance at 10 per cent.
The partner's dual role as fee earner and business owner can cause problems, as partners inevitably expect to be involved in the management of the business. In a smaller practice this is to be expected, but as the partnership grows it becomes difficult to cope with a large number of partners each with a managerial role. On incorporation, however, a board of directors is appointed to run the business, solving this problem.
The accounting regime for partnerships is far more relaxed than it is for companies, whose accounts are bound by the Companies Acts and accounting standards requirements. They must draw up accounts on an accruals basis reflecting both debtors and work in progress. Partnerships, however, can adopt one of a number of conventional bases including bills issued and the cash basis.
A partnership that draws up its accounts on a conventional basis may find itself with an unexpected tax bill on incorporation, since the previously unrecorded debtors and/or work in progress will come into charge. As a consequence of unlimited liability, partnerships enjoy secrecy concerning their financial affairs. There is no requirement for a partnership to lodge its annual accounts with Companies House, whereas a limited liability company has to make its accounts available for public inspection.
With the change of government there may come a degree of liability capping, the price of which may be greater public disclosure of partnership accounts, which partners may find an unattractive prospect.
Partnerships are also more flexible than companies. Partners can be admitted and retire, and the profit sharing ratios can be altered, all with little or no tax cost. A company's shares can only be transferred to other shareholders or potential shareholders, and on such transfers a tax liability can be triggered.
Shares also need to be valued for capital gains tax purposes and, where an incoming shareholder is offered shares at below their market value, there may also be an income tax liability to pay.
When it comes to selling shares, a former company shareholder will want to realise the full value of his or her holding. This means that individuals joining the business have to find substantial capital sums in order to purchase shares.
But several options are now available, and the distinctions between partnership and incorporation are becoming blurred. One accountancy firm incorporated just a part of its practice. Other firms are looking at the Jersey LLPs, assessing not only the tax consequences but how the various professional associations would regulate their activities in the UK.
And, of course, no one knows how the new Government plans to tackle the joint and several liability problems faced by partnerships.