8 November 2004
The move to limited liability partnership (LLP) status for UK law firms is gathering pace. The pressure for change is being driven not just by a desire to move away from unlimited personal liability, but by pressure to recruit and retain the best people, the need to tackle succession issues, the potential for enfranchising salaried partners, annuity arrangements and lease commitments.
Many law firms have a senior tier of employees – salaried partners – who are taxed under Schedule E and subject to Class 1 National Insurance contributions (NICs). LLP conversion is an opportunity to bring these people into a tier of equity participation. They will become members of the LLP and will be regarded as self-employed for tax purposes, taxed under Schedule D and assessed to Class 2 and 4 NICs. This can represent a significant tax saving for the firm, with the 12.8 per cent NICs employers’ contribution no longer applying. However, they will be giving up their employment rights. Matters such as redundancy, sick leave and maternity and paternity leave will be governed by the LLP members’ agreement and not by employment law.
It is possible to have salaried members of the LLP who are taxed as employees and employed by the LLP. They will be registered as members at Companies House. It would not be advisable to make these individuals partners without having them registered as members of the LLP. Any reference to a ‘partner’ after conversion should always be to a partner of an LLP. A claimant might otherwise assert that they believed they were dealing with a general law partnership. Firms that do not offer membership to salaried partners may expose themselves to claims for constructive dismissal/discrimination when they remove the ‘partner’ title.
LLP members have various statutory rights under the LLP legislation. It is a matter of debate as to how far these rights can be written out of a salaried member’s employment contract, if at all. Another topical development is that the Law Commission’s draft Partnership Bill proposes the abolishment of salaried partners. While this would only apply to general law partnerships, such a step may have repercussions for salaried members in LLPs.
The Inland Revenue has taken an interesting approach to the tax status of salaried members. Section 4(4) of the LLP Act 2000 allows for employed members of an LLP. However, Section 10 amends the tax legislation to the effect that the business of an LLP shall be treated as "carried on in partnership by its members". Relying on Section 10, the Revenue has, in some cases, sought to tax salaried members as self-employed. While this may have tax advantages for the firm, it is unsettling for those who have been reassured that their tax, employee status and rights remain unchanged by the conversion to an LLP.
A key issue in the preparation of the LLP’s balance sheet will be the allocation of the firm’s profits between the members. The LLP Statement of Recommended Practice (SORP) requires that profit, when divided between members, is not shown as part of the LLP’s reserves, but as a debt due to the members. Early allocation may have attractions for the members, but it will have the effect of weakening the LLP’s balance sheet. The SORP contains a legal opinion to the effect that provisions in the LLP members’ agreement which merely set out the members’ profit shares do not represent an agreement for the actual division of profits. Firms need to decide at what stage allocation to the members will take place. Some firms take a ‘mid-line’ approach and allow for automatic allocation of the members’ monthly drawings, while reserving allocation of the remaining profit until the approval of the LLP’s statutory accounts.
The SORP requires firms with annuity obligations to account for these on the LLP’s balance sheet as unfunded liabilities in accordance with Financial Reporting Standard 12. This was a vexed topic of debate between those responsible for the SORP. For firms with onerous annuity obligations, this requirement can have the result of ‘blowing a hole’ through the LLP’s balance sheet. There are, however, various methods of keeping these liabilities off balance sheet that have been adopted by a number of LLPs and the annuity issue may not be a bar to conversion.
US law firms
One growth area is the conversion of the London offices of US law firms to the Great Britain LLP, which creates an attractive structure for lateral hires and a sound platform from which to practise internationally. While LLPs have been available in most US states for some time, many of those states’ LLP statutes maintain the LLP’s status as a partnership, unlike the Great Britain model. Many US law firms operate in the UK as local partnerships, without any limited liability. Most advisers consider that, while admittedly untested, the Great Britain LLP (as a body corporate) will provide a more robust level of protection for its members than its US cousin. US statutes provide that the negligent partner in a US LLP is personally liable. That issue is left to common law in the UK and many believe that under the Great Britain LLP model this personal liability can be excluded on many types of legal work.
The stamp duty and stamp duty land tax exemptions on LLP conversion require continuity of membership and unchanged profit participations through the conversion process from the date of the incorporation of the LLP. Some firms have encountered problems where they have been in dispute with partners at the same time as trying to convert. Many partnership agreements do not address issues relating to conversion, such as what vote is required and what powers the firm is using to convert. Many partnership agreements are weak in the area of dissolution. Dissolution is a consequence of transferring the partnership’s business to the new LLP. Many firms do not have any meaningful provisions as to what they can do if a partner simply does nothing when asked to convert to the LLP. You cannot compel or sign up a dissentient partner to an LLP without willing consent.
Section 459, Companies Act 1985
It is surprising how many LLP members’ agreements do not seem to address Section 459 of the Companies Act 1985 and the LLP Default Regulations generally. Maybe those drafting them intend not to deal with these areas, being content, for example, for members to have rights to petition the court for their interests in the LLP to be bought for fair value. But this is doubtful. There have already been LLP disputes where members have been able to argue that they should be bought out for fair value, with very bad consequences and expense for the ongoing members. There can be very good reasons to allow all or part of the default regime to apply, perhaps particularly in smaller LLPs, but most law firms, and many of their clients, will be concerned not to create a fertile area for disputes, particularly given that these will be heard in public.
William Wastie is a barrister in the professional practices group of Mayer Brown Rowe & Maw LLP