The top players in the commercial legal sector could contribute hundreds of millions to public finances if the Treasury tweaked the tax rules, according to research undertaken by The Lawyer and Tax Policy Associates. It reveals that if the UK Government applied the employer national insurance contribution (NIC) on law firm partnerships, 100 leading UK and US firms would alone contribute £871m to the public finances.
As the Chancellor unveils his Autumn Statement today, there has been significant pressure to fill what the Office of Budget Responsibility has calculated as a £70bn fiscal black hole. As a thought exercise, The Lawyer and Tax Policy Associates have crunched the numbers and estimated how much law firms and partners could collectively and individually contribute to the public finances if the NIC rules were amended.
Law firm partner earnings have soared over the last ten years. In 2012, the average PEP at the magic circle was £1.2m. Since that time it has grown to £2m. The national firms have seen even greater increases. In 2012, average PEP at national firms DLA, Piper Eversheds Sutherland, Pinsents Masons and Addleshaw Goddard was £561,000. Since then it has doubled to £1.1m.
All the data points to the fact that commercial law is a highly successful UK sector that relies on an infrastructure of education, training and technology. In a climate of rising taxes for all, law firms will be increasingly challenged to consider their own financial contribution to the public finances.
Although law firm partners often earn as much, or more, than a highly-paid banker, there is one important difference: the lawyers pay less tax in their partnership vehicles, because even though modern law firms are effectively corporations, their self-employed status means there is no employer national insurance.
Partnerships of all kinds – limited liability partnerships, old-style general partnerships, and foreign partnerships, do not pay employer NI contributions of 13.8 per cent on distributions to partners, because partners are owners of the business and self-employed.
The theoretical tax take
For a broad indication of the potential tax take, we have calculated the UK net profits at the top 50 UK and top 50 US partnerships in the UK and applied a straight 13.8 per cent reduction, to mimic the effect of the employer NIC levy. We have taken the UK revenues of the UK-headquartered firms as reported in The Lawyer UK200 2022, to which we have applied the global profit margin. (In many instances this understates the level of distributable profit to UK partners since the London offices generate higher margins than other jurisdictions.)
The calculation of US firms’ UK net profits are taken from revenue figures in The Lawyer US Top 50 2022, to which we have applied a profit margin based on our understanding of each firm’s practice area and compensation per full equity partner.
The total net profit of these top 100 firms in our sample was £6.3bn, meaning that the potential contribution to public finances could be as much as £870m. The four magic circle firms alone would yield £178m in tax take on a combined UK net profit of £1.29bn, with Linklaters the highest contributor (£53m).
Meanwhile, US firms, which over the past five years have become dominant in the high-margin sectors of private equity and finance, could contribute £293m to the public coffers on their combined net profits of £2.1bn. The biggest contributions from US firms would come from Latham & Watkins and Kirkland & Ellis, at £30m and £28m respectively. Even the bottom firm out of this cohort of 50, McGuireWoods, which has just over 10 partners in London, would contribute £500,000 to the Treasury.
How would it affect individual partner take?
For most partners, the net profit figure and subsequent firmwide contribution through employer NIC is theoretical. How would they individually be affected? To answer this, we calculated the effect of the employer NIC on average PEP. If we take the top 50 UK-headquartered firms, magic circle partners would contribute between £257,000 (Linklaters) and £285,000 (Freshfields).
Or, indeed, you could frame it another way; that the savings that individual equity partners make because of the current tax regime, amounts to a quarter of a million pounds a year. Whichever way you look at it, a large slug of tax is mitigated by the fact that the resulting average PEP is still sky-high, between £1.61m (Linklaters) to £1.78m (Freshfields) – a figure akin to their 2020 PEP figures.
Outside the magic circle, a Macfarlanes partner would contribute an average of £342,000, but would still be left with £2.1m. Five firms would see their PEP dip below the psychologically-satisfying £1m mark: Eversheds, Simmons, Fieldfisher, Mishcon de Reya and Travers Smith. However, the law is undoubtably full of exceptionally wealthy individuals. Even at Weightmans, which has the lowest PEP of the top 50 firms in this ranking, an average partner would drop from £297,000 to a still-comfortable £256,000.
According to Tax Policy Associates founder Dan Neidle, a former Clifford Chance partner, there would be little technical difficulty in making the change. ‘It would be rational to start charging employer’s national insurance on partner earnings when partnership profits reach a certain threshold – say £100,000,’ he suggests. ‘To avoid a cliff-edge effect, it would make sense to phase in any new charge, with it gradually increasing as profits increase, rather than applying in full when the threshold is hit.’
Neidle believes any reforms should apply to all forms of professional partnership – so accounting firms and management consultancies as well as law firms, and to firms structured as corporates as well as those structured as partnerships. The total revenue raised could be somewhere between £1.5bn and £2bn, he calculates.
The big picture
There’s no suggestion that the current situation represents a loophole or tax avoidance. ‘No law firm is doing anything wrong – it’s simply the way the rules work,’ says Neidle. ‘The question is whether, with law firm earnings hitting the stratosphere, it’s fair that they continue to work this way.
‘The way the tax system penalises employment income is perverse, and this is a particularly hard example to defend. Low paid workers bear the burden of employer national insurance – so do highly paid bankers. Why shouldn’t law firm partners?’
In the long-term, Neidle would eliminate employer national insurance altogether, rolling it into income tax. ‘Then all forms of income would be taxed the same way, which is how a fair and rational tax system would work.’ On this basis, law firms and other professional partnerships are an easy first step.
Tony Williams, of Jomati Associates, takes a historical view. ‘The rationale for the differential between the national insurance contributions paid in relation to employees and the self employed is that the self employed do not have access to certain benefits such as unemployment benefit,’ he notes. ‘However, as the benefits system and pensions system has evolved there is probably less justification for such a large discrepancy in the total paid in relation to employees – both employer and employee contributions – and that paid by the self employed.’
Is a partner in a law firm truly self-employed? The question of ‘what is a partner’ has exercised tax authorities before. ‘HMRC has already had a bite at this cherry by introducing the salaried member rules,’ says Aster Crawshaw, a partner in Addleshaw Goddard’s professional partnership advisory group. ‘This resulted in LLP members who are more like employees being taxed as employees, and so employer’s NICs applying. Rather than simply taxing all LLP members as employees, if the Government wanted to do something in this area it seems to me more likely that they would try to tighten up the salaried member rules, so to make a sharper distinction between employed and self-employed status.’
How might law firms respond?
Should the Treasury decide to apply employer NIC to partnerships, it would face significant opposition from law firms – and there may only be a small window of opportunity before firms restructure. ‘Most partners in professional services firms willingly pay high marginal income tax rates,’ argues Crawshaw. ‘As a group they are very conservative: they pay their tax in full, on time, and rarely do much to mitigate their tax bills.’
Williams agrees, adding: ‘It needs to be understood that the clawback of personal allowances, restrictions on pension contributions and a range of business expenses that are not tax-deductible means that many partners in the more profitable firms already have an effective tax and NI rate of over 50 per cent.’
The option of a limited company status rather than LLP is not necessarily aggressive tax planning, whatever the socio-political optics; from a tax perspective, they are both considered relatively vanilla. ‘The pros and cons of operating through an LLP rather than a limited company are quite finely balanced, and if it became much more expensive to run a business through an LLP many firms will inevitably move over to the limited company,’ predicts Crawshaw.
‘The difference between the two is relatively marginal, so a significant change to the LLP tax regime could well tip the balance for many. Tax is obviously not the only factor firms take into account when choosing their business structure, but it is an important one.’
Political reality, however, might intrude. ‘It comes back to the point of fair wealth distribution,‘ one senior accountant confides. ‘Is it a good look for lawyers to be earning so much when there’s no money for schools?’
Additional research by Vitesa Fetahu and Nikhil Raj Aggarwal. For more data from The Lawyer UK200 click here.