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In the past, becoming a self-employed LLP member has often meant complex calculations of the new member’s taxable profit share for the first few years, and dealing with the creation of “overlap profits”. The new rules that came into affect on 6 April 2014 for fixed share members of LLPs have added more complexity, and all may not be as it seems.
By way of a reminder, the introduction of new rules prompted firms to decide what action to take for their fixed share members to be able to remain self-employed for tax purposes.
“Of the three choices available (variable profit shares, increased influence and injection of capital), in our experience by far the most popular route for remaining self-employed has been the making of a capital contribution.”
Condition C of the new rules requires the fixed share member to have made a capital contribution equating to 25% or more of the amount they reasonably expect to be paid by the LLP during the tax year in question.
The position is relatively straightforward for existing members at 6 April 2014 who had made the required contribution by that date (or by 5 July 2014 in certain cases). However, there are some pitfalls to watch out for in other situations.
Existing self-employed members making additional contributions
Where an existing member made the required contribution at 6 April 2014 (or by 5 July, where applicable) based on their expectation on 6 April of their profit share for the coming tax year, they continue to be taxed on a self-employed basis. If there should be an increase in their expected profit share part way through the tax year, which was not expected at 6 April, and therefore not taken into account in the assessment made on that date, it is necessary to reassess the level of their capital contribution, and additional capital will need to be contributed to remain self employed for tax purposes.
Robert, a long-standing LLP member, receives an annual profit share of £80,000. At 6 April 2014 there was no expectation that his profit share would change during the year to 5 April 2015, and so he made a capital contribution of £20,000 to remain self-employed. On 22 December 2014, following a particularly lucrative client win, the board decide to reward Robert with an increased profit share of £90,000, effective from 6 January 2015. This change in Robert’s circumstances means that he now expects to receive £82,500 (£80,000 x 9/12 plus £90,000 x 3/12) in the year to 5 April 2015, so his capital contribution needs to be increased if he wishes to remain self-employed for the rest of the tax year.
Robert needs to increase his capital contribution to £20,625 (£82,500 x 25%) by 6 January 2015, or he will be taxed as an employee from that date. There is no grace period for introducing the additional capital.
In addition, as his capital contribution is reassessed on 6 April each year, in order to remain self-employed throughout the 2015/16 tax year Robert will need to increase his contribution to £22,500 (£90,000 x 25%) by 6 April 2015, assuming no change is expected to his £90,000 profit share. For simplicity, Robert may decide to increase his contribution to £22,500 from 6 January 2015, cash flow permitting.
Existing members taxed as employees
Where existing LLP members have made no capital contribution by the required date, or where the contribution is less than 25% of their profit share, they are taxed as an employee from 6 April 2014. If the member subsequently increases their capital contribution in order to become self-employed, a special rule applies a
fraction to the individual’s contribution, thereby potentially reducing its value when applying the 25% test. The fraction is calculated as the number of days from the date of the additional contribution to the end of the tax year divided by the number of days in the tax year.
This is best illustrated using an example:
Linda has been a member of an LLP for many years, receiving an annual profit share of £100,000. At 6 April 2014 she had made a capital contribution to the LLP of just £5,000, so she was taxed as an employee from 6 April 2014. On 1 December 2014 she contributes a further £20,000 to the LLP in an attempt to become self-employed, but her contribution is deemed to be £8,630 (£25,000 total contributions x 126 days /365 days) for the purpose of the test.
As she is deemed to have only contributed 8.63% of her profit share for the tax year, she remains employed for tax purposes.
In order to become self-employed, Linda would need to have contributed at least £67,421 (£25,000 x 365 days / 126 days less the £5,000 already contributed). The later in the tax year the contribution is made, the greater it needs to be. If Linda had made the contribution on 1 January 2015 it would need to be £91,053 for her to become self-employed. The logic behind this measure is pretty questionable, but it seems HMRC require a 25% contribution to have been in place for the full tax year, and a contribution made part way through the year must be pro-rated.
The test is recalculated at the start of each tax year, with no pro-rating of contributions, so Linda might prefer to wait until the start of the new tax year before making the further £20,000 contribution. That is unless she can afford to make the exceptionally large contribution and wait until the start of the new tax year to then withdraw the excess.
As explained above, the test to calculate whether a member’s capital contribution is sufficient is based on their profit share for the tax year. For a new member joining part way through a tax year it would, on first glance, appear that a reduced capital contribution can be made initially, as a full year’s profit share will not be received in the first tax year. However, the fraction calculated above is also applied to the contribution in this situation.
There is a detailed calculation involved, but the overall effect of this is that the member must effectively contribute at least 25% of their annual profit share, regardless of the date on which they join the LLP, which is arguably a reasonable outcome.
Applying the 25% test at 6 April 2014 and at the start of subsequent tax years should not present too many difficulties, but at all other times care needs to be taken to ensure the correct amount of capital is contributed to secure self-employed status.
This release has been prepared as a guide to topics of current financial business interests. Hazlewoods strongly recommend you take professional advice before making decisions on matters discussed here. No responsibility for any loss to any person acting as a result of the material can be accepted by Hazlewoods.