In an increasingly contentious and litigious society, the offer of a partnership with unlimited personal liability for the firm's debts is nowadays not always the attraction it might once have been to an aspiring professional. Several jurisdictions have, therefore, evolved forms of partnership that seek to limit their members' liability to the capital they have contributed to the firm. I shall examine here, and in a second article in next month's Accountancy, the UK's version of the limited liability partnership and in particular the way LLPs and their members will be taxed.
LLPs will become possible as business vehicles in the UK from 6 April 2001, the date that the Limited Liability Partnerships Act 2000 (LLPA) comes into force. From the same day, various changes to the Taxes Acts, which have been inserted by the LLPA, will also take effect. The final element of the legal framework for LLPs will be added by regulations dealing with their corporate governance and accounting procedures, which appeared in draft early in January 2001. The Department of Trade and Industry, the Inland Revenue and Customs & Excise have consulted in detail on the statute and regulations with the professional bodies.
The Revenue published a helpful set of notes on the taxation of LLPs in its Tax Bulletin for December 2000, and I shall refer to these in both articles. The notes can be read on the Revenue's website: www.inlandrevenue.gov.uk.The nature of the LLP
Briefly, the LLP has some of the legal characteristics of a company in UK law, and some of those of a partnership. Like a company, an LLP will have legal personality as a 'body corporate', and many of the procedures for setting up, and winding up, an LLP are borrowed from those applicable to companies. Crucially, the liability of members (not 'partners') to contribute to the LLP's debts is limited to the LLP's assets, and there is no recourse to their personal assets, except in the case of a member who has been personally negligent.
LLPs will normally be governed internally by an agreement between members, which will perform the functions of a partnership agreement in the more familiar conventional (unlimited) partnership. However, the draft regulations provide for default provisions, mainly derived from the Partnership Act 1890, which come into play where the members' agreement is silent or non-existent.
Although the original consultation paper on LLPs issued in September 1998 envisaged that LLP status would be available only to regulated professional businesses, this idea rapidly proved unpopular and was abandoned. Any trade, profession or other business, therefore, regulated or not, will be possible for an LLP. However, as noted below, there are expected to be some further taxation provisions aimed at discouraging the use of LLPs for activities the Revenue perceives as objectionable tax avoidance.Taxation of LLPs: the 'transparency principle'
Although the LLP has many of the legal attributes of a limited company, the government recognised from the start that existing firms would be reluctant to adopt LLP status if the tax regime was unattractive. To tax LLPs in the same way as companies would have meant that members' remuneration was subject to employers' NICs, together with possible income tax charges on conversion and capital gains tax disadvantages on liquidation.
The basic approach of the LLP taxing rules is therefore to treat the LLP as transparent for income tax and CGT purposes. Profits will therefore be subject to income tax, and not corporation tax (though, as will be noted later, there can be exceptions to this rule in some winding-up situations). The profits will, furthermore, be taxed exactly like those of an unlimited partnership - as those of the members and not the LLP itself. Each member will be taxed directly on his share of profits and will be personally and solely liable for that tax. Consistent with this approach, when an unlimited partnership converts itself into an LLP this should, in theory, be a tax-neutral event; but as we shall see later, in practice it may not be quite that simple.
We will now look in more detail at the treatment of LLPs for the purpose of the various taxes.Income tax treatment of profits
While the LLP is carrying on a business with a view to profit, its members will be treated for income tax purposes as if they were partners carrying on the business in partnership.
Each member who is an individual will therefore be subject to income tax on his share of the business's profits, allocated in accordance with the members' agreement. The basis of assessment in any year of assessment will be exactly the same as in an unlimited partnership; in other words, the share allocated in the accounting period that ends in that period. The commencement and cessation provisions for tax purposes will also be those applicable to an unlimited partnership. As with such a partner-ship, each member will report his profit share on his personal tax return and the LLP itself will submit a return for the business as a whole. Each member's return will also include his share of any investment income arising to the LLP, which will likewise be taxed exactly as in an unlimited partnership.
There is nothing to stop a limited company being a member of an LLP, and its share of profits will be subject to corporation tax, again exactly as occurs in an unlimited partnership.Computation of taxable profits
From 6 April 1999, all businesses, incorporated or not, have been required to compute their taxable profits using 'true and fair' accounting, subject to the specific requirements of taxation statutes and case law. The same principle will apply to LLPs, but with the important modification that LLPs will be required to adopt specific accounting practices as reflected in the Statement of Recommended Practice currently being drafted.
A practical impact of the SORP may be on the treatment of members' time included in work-in-progress. At the time of writing, the final version of the SORP is still awaited, but it seems likely that it will adopt the principle that members' time does not need to be included in work-in-progress, though overheads relating to members may need to be included. The latter element may, therefore, result in somewhat higher work-in-progress figures being reflected in the tax computations of firms that convert to LLP status, while preserving the important exclusion of members' (formerly partners') time.Losses
For professional businesses that adopt LLP status, there will be no material differences in the tax treatment of losses. Like profits, they will be allocated among members according to the agreement and relieved for tax purposes, if required, against the member's total taxable income for the tax year in which the accounting period ends, and/or the previous tax year (sometimes called 'sideways' relief). In so far as they are not relieved in this way, they can be carried forward to be set against future shares of profit as long as the business continues and the individual is a member of the LLP.
Where the LLP carries on a trade rather than a profession, some complex rules will come into play, to some extent borrowed from the current rules (in s 117, ICTA 1988) that apply to limited partnerships under the Limited PartnershipsAct 1907. The details here are beyond the scope of this article but in essence they will restrict 'sideways' relief - against the member's total taxable income - to his contributed capital, including undrawn profits if the agreement treats them as capitalised. Once relief has been given up to this limit, any unrelieved losses can only be carried forward.
Examples of the rules appear in the Tax Bulletin article mentioned above. This feature of the tax rules requires a distinction to be made between a 'trade' and a 'profession', which may not be easy - the existing (mostly old) case law is rather ambiguous.
In any event, the unfortunate member who finds himself personally liable for losses resulting from his own negligence should be able to obtain tax relief against his total taxable income - provided it is large enough - for the full amount he is required to contribute.Interest relief
Where members borrow money to contribute capital or make loans to the LLP for use in its business, they will be able to obtain tax relief for the full amount of interest paid in the same way as partners in an unlimited firm at present.Annuities
Members of an LLP who are responsible for paying annuities to retired members will be able to obtain higher-rate income tax relief for their shares of this obligation. This will be a very important matter in many cases when deciding whether to convert to LLP status, which I shall cover in more detail in my next article.NICs
The transparency principle also applies to NICs. LLP members will remain subject to Class 2 and Class 4 NICs exactly as if they were partners in an unlimited firm. The LLP will not have to pay Class 1 employers' contributions on their remuneration, although these will, of course, be payable in the normal way in respect of its employees.Overseas matters
The LLPA applies only to LLPs registered in the UK. The taxation of UK branches of an over-seas-registered LLP will depend on the legal nature of that LLP as perceived by the Revenue; in some cases this may be that of a company, and if so the profits will be subject to corporation tax, less any available double taxation relief.
In the converse situation, where a UK LLP has a foreign branch that the local tax authorities regard as a company, the Tax Bulletin article confirms that UK resident members will be entitled to double taxation relief on their shares of the branch profits even though the foreign tax has been levied at 'corporate' level. They will also be directly entitled to any applicable tax credits on foreign dividends that the LLP receives.CGT
Unlimited partnerships are transparent for CGT purposes, with any tax liabilities being those of the partners. The same principle will apply to LLPs, so long as they are carrying on a business with a view to profit - we deal later with what happens when this is no longer the case.
In practice, the Revenue will treat disposals by members of their interests in an LLP as disposals of their shares in the underlying assets, and not as disposals of legal choses in action. This mirrors the treatment of unlimited partners as set out in Statement of Practice D12, which will be updated to cater for LLPs. Because these assets will be held for the purpose of a trade or profession in the normal case, members' interests should qualify for the more generous business asset taper relief, which now means that a higher-rate taxpayer can achieve an effective CGT rate of 10% after only four years of ownership.Rollover relief
Just as for a partner in an unlimited partner-ship, when a member of an LLP sells a privately owned 'qualifying' asset at a capital gain and then, within three years, acquires an interest in another such asset held in an LLP, rollover relief can be claimed to defer CGT on the gain until the LLP asset is sold. Assets that 'qualify' will include land, buildings, or goodwill used in a trade or profession. The same relief will potentially apply in reverse, where an interest in a 'qualifying' LLP asset is sold and 'qualifying' assets acquired.Losing transparency
The transparent treatment of an LLP for CGT only continues for as long as it is carrying on a trade or business with a view to profit. Once this is no longer the case, the CGT treatment reverts back to the underlying legal position, and the LLP is treated as a company for tax purposes. Members' interests in the LLP are treated as if they were shares in the company. Finally, any 'rolled over' gains are crystallised, and CGT on them becomes payable.
This could have awkward results if an LLP ceased to engage in any business activities - for example, when it was in the process of being wound up. Strictly, corporation tax would be due on gains made at LLP level, with CGT being due on gains members made when they 'realised' their interests on liquidation. This is another version of the well-known 'doubletiering' of CGT, which is one of the main drawbacks in a corporate structure.
However, the Revenue's December 2000 Tax Bulletin offers what should normally be a practical solution. Where members wind up the LLP's affairs informally without undue delay, initially without appointing a liquidator, and where tax avoidance is not a motive, the LLP can continue to be treated as tax-transparent in the meantime. The preferred method of winding up will therefore often be to achieve a gradual disposal of assets and settlement of debts, with a liquidator appointed only for the final formalities after all the main disposals have occurred.Tax avoidance and LLPs
In his November 2000 pre-Budget report, the chancellor began a consultation on methods of discouraging the use of LLPs for tax avoidance. The main concern here appears to be the possibility of LLPs being used as investment-holding vehicles, and the intention is to deny tax relief for interest in such cases. There are also likely to be rules to stop tax-exempt bodies exploiting their status by membership of LLPs. The final version of these rules will not be known until the Finance Act 2001 has become law.
Simon Mabey FCA ATII is a partner in Smith & Williamson, chartered accountants, and on behalf of the Association of Partnership Practitioners has co-ordinated consultation with the tax authorities on the legislation and regulations governing LLPs. His second article will look in more detail at the tax implications of converting an existing unlimited partnership into an LLP. For articles on the law relating to LLPs, see Accountancy, February, pp 120-121, and this issue, pp 126-128.