Many professional services firms, particularly within the legal industry operate through a Limited Liability Partnership (LLP), with the Members of the LLP being equivalent to directors and/or shareholders of a limited company.
What happens when an employee of a legal practice becomes a Member?
It is important that when an employee is invited to join the LLP that they fully understand the implications of becoming a Member of the LLP and the change this will bring to their income tax and National Insurance (NI) status.
When someone becomes a Member of an LLP, they will need to adhere to the LLP Members’ Agreement and ensure they register as self-employed with HM Revenue and Customs (HMRC). If the Member is to become a Designated Member they will have additional responsibilities to ordinary Members, being to ensure;
- adequate accounting records are maintained
- the LLP files accounts with Companies House on time
- the LLP files a Tax Return on time
- an annual Confirmation Statement is filed with Companies House
- changes to the LLP are registered with Companies House such as changes to Members
What should I tell them about the change to their Tax and NI position?
The new Member will need to understand that instead of being an employee and taxed at source, they are now self-employed and responsible for self-assessing their own income. It is important to note that an LLP does not pay tax itself and each member is responsible for their own taxes.
Existing Members of the LLP will need to arrange for accounts to be prepared up to the day prior to the new Member joining the LLP to ensure each Member is allocated the correct amount of profit/loss around the date of change.
At this point it is recommended that the new Member speaks to an accountant to make sure they understand the following:
- Basis periods: newly self-employed people are subject to the ‘opening rules’ to determine how they are taxed in their first period of trading and the first tax year for which they need to self-assess. Typically, the date on which the Member starts to trade up to the following 5 April will be the first tax year under self-assessment, for example a Member joins from 1 September 2022, so their first period will be from 1 September 2022 to 5 April 2023, meaning their first tax year is 2022/23.
- The accounting period taxed in the following tax year, 2023/24, will depend on the LLP’s accounting period and the length of that period. There are separate rules here and the newly self-employed should seek advice to ensure they are taxed on the correct amount of profits *.
- National Insurance (NI): the member will move from paying Class 1 Primary NI as an employee to paying Classes 2 and 4 NI.
- Pension contributions: the new member will no longer be part of pension auto-enrolment and should consider seeking advice regarding their pension contribution options from a suitably qualified adviser.
- When Income Tax and NI is payable. The Member will have to consider how they will ensure they can meet their Income Tax and NI liability because their liability is no longer deducted at source through payroll. Instead, they will pay tax in January following the end of the tax year and potentially be required to make payments on account too, for the following tax year, each January and July.
It is good practice for LLPs to have a Members’ Agreement in place which covers matters such as profit/loss allocation, capital repayment, introduction and exit of Members, management of the LLP and so on.
These Agreements can ensure the smooth operation of the LLP particularly when changes are needed or there are disagreements.
Several years ago, HMRC introduced rules to prevent LLPs taking advantage of NI savings by treating employees as members and self-employed, but those Members were in essence still employees. These rules are known as the disguised remuneration rules and if any one of the conditions below is met the Member is considered an employee and must be taxed through the PAYE system.
Condition A: Disguised salary
Where a Member is providing services personally to the LLP in their capacity as a Member and 80% or more of their remuneration is either fixed, or variable without reference to the overall profits of the LLP, or generally not affected by overall profits/losses of the LLP, then this condition is met and the Member will be taxed under PAYE.
Condition B: No significant influence over the affairs of the LLP
If a Member has no significant say in how the LLP is managed this condition is met and the Member is taxed under PAYE. For example, if a Member is not involved in management meetings, or does not have any say in management, it is likely they have no significant influence.
Condition C: No significant investment in the LLP
If the Member has less than 25% of the amount defined as ‘disguised salary’ invested in the LLP, this condition is met and the member is taxed under PAYE.
* Basis period rules will be changing with effect from 6 April 2024.
As you would expect from a firm of chartered accountants, we offer a comprehensive range of accounting and tax services for our clients that operate in the Legal Sector.
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