Structural shift

With limited-liability partnerships becoming ever more popular across the whole gamut of law firms, Colin Ives gives a rundown of the issues that need to be considered

Since its introduction on 6 April 2001, limited-liability partnership (LLP) status has become an increasingly popular vehicle through which professional practices can operate. Professional firms as diverse as Allen & Overy, regional firm Stevens & Bolton and surveyors Knight Frank have all opted to convert to LLP status.

Essentially, LLP caps the financial exposure partners to prevent them suffering the consequences of unlimited liability caused by the acts of fellow partners. Litigants unable to pursue the individual assets of all partners may consider allowing firms to trade through their difficulties. This may produce a higher yield for the litigant compared with what they would have received had they ‘busted’ the firm. Nevertheless, the partner’s entire interest in the LLP will remain at risk, and there could be additional exposure in respect of any personal guarantees given, ‘excessive drawings’ made in the previous two years or partners’ negligent acts.

Similarly, the LLP structure does not negate the need for professional indemnity insurance, it simply prevents the ‘firm-busting claim’ from bankrupting all of the partners. Going forward, however, firms may find that they do not need to raise their top level of professional indemnity cover, except where necessary due to a particular client or commercial driver.

Another advantage for firms converting to LLP status is the opportunity to modernise their risk-management processes. Conversion inevitably requires some client involvement and should be accompanied by a review of the firm’s engagement terms. It is essential that the terms are worded appropriately, stating clearly that the contract is between the LLP and the client, and that any partner or member is responsible purely as an agent of the LLP. Failure to introduce appropriate terms can negate the benefits of LLP status and may in certain circumstances result in the member owing a duty of care to the client, such that the member has unlimited liability in relation to the work performed. This is also a suitable time to consider other aspects of risk protection, such as liability caps and proportionality clauses.

The other side of becoming an LLP is the public disclosure of accounts, remuneration levels and names and addresses of partners. The public filing of accounts makes it easier for the press to compile details about the financial position of firms, which is likely to generate interest when first made publicly available. Criticism about ‘fat cat’ salaries – synonymous with firms generating sizeable profits – might deter a firm from seeking LLP status, although revelations of poor profits are likely to be even more discouraging. However, any interest is likely to be short-term as far as the public is concerned and the information published is not as detailed as some fear.

Ultimately, firms will need to weigh up the advantages and disadvantages of public reporting against the added comfort of limited liability, which is a significant improvement on the unlimited liability to which a partner in a traditional partnership is exposed.

Another area that will need to be considered when converting to an LLP is the presentation of the firm’s balance sheet and profit and loss account following incorporation. The firm will need to convert its accounting policies to those that qualify under UK GAAP, which may affect how the firm’s solvency and reported profitability are perceived. In addition, the timing of profit allocations to members may affect the firm’s balance sheet. If all profits are allocated by the year-end they will be treated as a liability to members. Therefore the balance sheet could appear weaker than that of a traditional partnership. Some firms delay the allocation of profit until after the accounts have been signed, thus delaying recognition of the liability and in theory strengthening the shape of the firm’s balance sheet.

A significant issue in the conversion process is the handling of salaried, or ‘fixed-share’, partners or members. HM Revenue & Customs (HMRC) currently classes these individuals as “self-employed for taxation purposes”. However, Clause 4(4) of the LLP Act 2000 states that a member of an LLP shall not be regarded for any purpose as employed by the LLP unless, if they and the other members were partners in a partnership, they would be regarded for that purpose as employed by the partnership.

Individuals intending to be treated as self-employed for tax purposes, then, should satisfy the recognised criteria for the self-employed rather than rely on the current HMRC view, which may be subject to change. Employment law and pension issues in relation to the status of the individuals concerned and their employment rights must also be considered.

It is likely that LLPs will become standard among law firms over the next few years. The marketplace has shifted to such an extent that all professional partnerships should now be considering whether LLP conversion is right for them.

To avoid the cost of development time incurred at the client’s expense, when LLP legislation was first introduced it was suggested that some firms wait for advisers to establish ‘precedents’. There are now several quality firms with standardised, yet adaptable, documentation available, having advised on a number of LLP conversions.

At present, specialist advisers are involved regularly in LLP conversions. This means that professional fees associated with conversions are highly competitive. In reality, though, the cost of conversion is not dominated by the fees of external advisers but rather the cost of internal management time. However, firms that have already converted are demonstrating their responsiveness to changes in the business environment, and this, together with limited liability, makes them less of a risk to the partner promotee or lateral hire. Unlike those who have been in a partnership and are accustomed to unlimited liability, a lateral hire may prefer the protection an LLP affords, while senior staff members who are offered a partnership could find themselves thinking the same thing.

Colin Ives is a tax director at accountants and financial advisory group Smith & Williamson