Business Structures: LLPs
Limited Liability Partnerships
LIMITED LIABILITY PARTNERSHIPS, or LLPs for short, are a new type of business structure for the 21st Century. Although LLPs have now been with us for 12 years, they are still not well understood. Which is a pity because LLPs provide some very good tax planning opportunities for those whose business is classed as a ‘profession’.
The drive to legislate for the creation of LLPs in the UK was led by large firms of accountants and lawyers seeking a way to obtain the commercial advantages of limited liability combined with the tax advantages of a partnership.
An LLP may therefore best be described as a ‘hybrid’ entity: part limited company and part partnership. It is as if a company and a partnership got married and the LLP was their offspring.
From the company side, LLPs have inherited limited liability. The members of an LLP are not subject to the perils of joint and several liability like traditional partners. A member’s personal liability is limited to the amount invested in their capital account: similar to the position of a company shareholder.
The downside to this is that, like a company, an LLP must file accounts and returns with Companies House on an annual basis and, if it is large enough, may also need to be audited.
As long as it is making profits, an LLP is taxed very much like any other partnership. The members of the LLP are therefore taxed in the same way as other business partners – they pay Income Tax and National Insurance on their share of the LLP’s profits and Capital Gains Tax on their share of any capital gains.
This is seen as an advantage to large professional partnerships that desire the protection of limited liability without using a company because it means that all of the partners (a.k.a. members) pay Class 4 National Insurance instead of Class 1 and the LLP does not suffer employer’s National Insurance on partners’ remuneration. Hence, the National Insurance rate on partners’ pay is kept down to 9% on the basic rate band and 2% thereafter. If these partners had been company directors instead, the overall effective rates of National Insurance would have been 25.8% on the basic rate band and 15.8% thereafter.
For smaller partnerships, the advantage is less clear because it would also have been possible to form a company and pay the owner/directors by way of dividends - thus avoiding National Insurance altogether. But then, when times are not so good, there is also loss relief to think about!
Once the LLP starts to make losses, the similarity in tax treatment to a traditional partnership starts to break down. At this point, we have to divide LLPs into three categories: trades, professions and investment LLPs.
Losses arising in an LLP created to carry out investment activities (e.g. property investment) are effectively ‘ring-fenced’ and can only be carried forward for offset against future profits from the same activities.
The position for a trading LLP is not much better. The members are only able to claim ‘sideways loss relief’ (i.e. relief against their other income) up to the amount of the capital they have invested in the LLP. This is the amount invested in the member’s capital account and does not include the amount of any loans to the LLP. It may, however, include previous profits not withdrawn and retained within the member’s capital account.
Contrast this with sole traders or traditional business partners who may usually claim full relief for their share of any losses (except where they are classed as ‘part-time’).
A professional LLP fares much better – after all, these are the people that LLPs were created for!
Members of a professional LLP generally retain full rights to ‘sideways loss relief’ in the same way as other business partners. This means that losses may be set off against other income or capital gains arising in the same tax year or the previous one.
It also means that losses arising in any of the first four tax years for which the individual is a member of the LLP may be carried back for relief against their other income in the three tax years prior to the loss-making year. This is immensely useful to individuals who have previously had highly-taxed employment income and now wish to enter self-employment through an LLP. But only if they are carrying on a profession!
Remember that losses arising in a company cannot be set off against shareholders’ personal income so, where there may be losses in the early years of a professional business, an LLP becomes very attractive. Furthermore, we are talking about tax losses here – not necessarily commercial losses. If the LLP spends a large amount on business premises, equipment, commercial vehicles, computers, or other qualifying items, it will be able to claim a significant amount of capital allowances. Where these allowances exceed the current income in the early years of the business, they can effectively be carried back and set off against the members’ own income in the previous three years.
In other words, members of a professional LLP can usually get tax relief for a large part of their set-up costs. Company shareholders have to wait until the company is able to set the costs against its own profits.
What Is A Profession?
For many decades, the tax treatment of a trade was completely indistinguishable from the tax treatment of a profession. As a result, it became totally unnecessary for anyone to decide when something was a trade and when it was a profession. So there is very little case law on the subject and absolutely no statutory definition. We are therefore left with one of those horrible ‘grey areas’ which are the scourge of UK taxation and no-one really has a proper answer to the question.
Certain activities are definitely accepted as being professions, including accountants, lawyers, doctors, vets, dentists, other medical practitioners, and surveyors. These are what one might call the ‘traditional’ professions.
But there are many other activities in the modern world where the issue of whether it is a ‘profession’ has never been tested, such as: IT consultants, estate agents, dog groomers, pest controllers, etc, etc, - the list is endless. Whether these less traditional activities would be accepted as a profession is totally unknown!
LLPs have many advantages for the type of people they were created for – professional partnerships. Large partnerships benefit from substantial reductions in National Insurance liabilities and smaller partnerships will often benefit from access to loss relief which would have been denied to them if they had used a company.
For trading businesses, however, the restrictions in loss relief mean that LLPs lose a significant part of their advantage. Whilst there are exceptions, most trading partnerships wishing to save National Insurance whilst benefiting from limited liability would be better off using a company.
Like any other partners, members of an LLP who work an average of less than ten hours per week in the LLP’s business are subject to further restrictions in their loss relief.
Firstly, the total loss relief which may be claimed in any tax year from all such part-time roles (including part-time sole trades) is capped at a maximum of £25,000.
Secondly, relief is also restricted to the amount of capital invested in the LLP (even if it carries on a profession).
Thirdly, any amounts invested with a tax avoidance motive cannot be included within capital invested for loss relief purposes.