Categorising partner pay post-pandemic

Kate Arnott, head of professional services, partner at MHA MacIntyre Hudson, outlines the three tests firms need to keep in mind to ensure they’ve correctly categorised partners’ pay after a year of financial disruption.

In 2014, legislation was introduced under which, in certain circumstances, a member of an LLP would be treated as employed for tax purposes.

There has, in fact, been little evidence of HMRC seeking to test the application of those rules, within the context of professional partnerships. That, of course, does not mean the rules have gone away and it is up to any practice operating as an LLP to satisfy itself that its members do not fall foul of the rules.

The legislation is framed in such a way that, where all three conditions are met, the individual member will be characterised as an employee for PAYE purposes:

• Disguised salary (Condition A) The member performs services for the LLP in their capacity as a member and is expected to be wholly or substantially rewarded through a ‘disguised salary’ that is fixed or, if variable, varied without reference to the profits or losses of the LLP.
• Significant influence (Condition B) The member does not have ‘significant influence’ over the affairs of the LLP.
• Capital contribution (Condition C) The member’s contribution to the LLP is less than 25% of the ‘disguised salary’.

Tests relating to each condition operate on an either/or basis: if, looking forward, you expect at least 20% of a member’s profit share to be truly variable by reference to firm profitability and/or they have real influence over the operation of the firm and/or their contribution to the firm exceeds 25% of their fixed-share of profit (so as to include awards that relate to personal rather than firm performance), the salaried partners legislation will not apply.

The situation created by Covid-19 begs the question, in the case where protection from the salaried partner legislation is afforded only by Condition A and where an individual receives both fixed-share and a profit-related share from an LLP’s profits, the point at which they might be characterised as an employee for PAYE purposes.

Generally, when looking at the allocation of profits to a partner, it’s natural to assume that fixed-shares and personal performance-related awards constitute a first share of profit and that the firm profit-related amount constitutes the final element of the individual’s profit share.

It follows that, where a firm’s profitability is expected to be negatively impacted by Covid-19, one would expect the profit-related element to decrease. While the test is expressly to be applied looking forward rather than back, where for a year an individual’s variable profit does not meet the 20% test, it may call into question whether, at the point at which Test A was due to be considered, it did apply.

Many firms rely on condition C (capital contribution). This does require ongoing monitoring as increases in fixed-shares might result in the salaried partner rules applying.

Now is a good opportunity to revisit the salaried partner rules to ensure the characterisation assumptions made have survived the passing of time and the financial impact of Covid-19.