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Limited Company or Limited Liability Partnership – which would you choose?

A few years ago, the answer would most likely have been a Limited Liability Partnership (LLP) but evidence produced by the Solicitors Regulation Authority (SRA) in February 2017, shows a remarkable move away from this model. RSM explore why.

The number of law firms now operating as companies in England and Wales (4,290) exceed the combined number of LLPs (1,552) and unincorporated partnerships (1,921). However, almost all of the very largest firms continue to operate with an LLP structure so the LLP is by no means dead. How should you decide what the right model is?

Think about your strategy

Strategy must always come first and then a suitable legal structure adopted to facilitate those strategic ambitions. Don’t do it the other way round.

Objectives when building a strategy may include some or all of the following.

  • Retention of profits to finance expansion or as a contingency against future threats – Brexit for example.
  • Investment in new technology – new practice management systems and CRM systems perhaps, or a more radical adoption of Artificial Intelligence.
  • Retaining talent to grow the business.
  • Attracting external investment.
  • Building a platform for future sale or flotation.
  • Employee participation through tax efficient remuneration.
  • Building capital value.

Why does structure matter?

The problem is that most of these very commercially driven objectives are difficult or impossible to achieve in a traditional partnership or an LLP structure. This is because:

  • Undrawn profits are subject to marginal rates of tax (generally up to 47% – 49% following the 2% NIC increase in April 2019 announced in the Spring Budget)
  • External equity investment is difficult to accommodate in an LLP structure
  • Employee share participation is almost impossible
  • LLPs cannot be floated and do not have marketable paper to assist in acquisitions.

On the other hand, a corporate structure can achieve many, if not all, of these objectives as well as providing a much more streamlined management and decision making function.

From a tax perspective, the difference between corporate and personal tax rates on retained profits is typically 27%, (corporation tax is currently 20% falling to 17% by April 2020 and further proposed reductions to 15% have been suggested).

At the very least therefore, incorporation is an attractive prospect for firms looking to retain and reinvest profits to support future growth, even if they do have not seek to achieve some of the other points raised above.  The SRA figures show that more and more firms are taking this route.

So why would you have an LLP structure?

An LLP provides flexibility. If you regularly have new partners joining and existing partners retiring then this can be accommodated far more readily within an LLP structure because no share transfers or valuation issues arise.

But perhaps the main reason is that many firms still really value a partnership ethos and are reluctant to embrace a move to full incorporation. This is understandable.

Some have tried a halfway house by adopting a mixed partnership, involving the introduction of a corporate partner This enabled a means of providing some of the benefits available through incorporation whilst retaining an individual's partnership. However, the introduction of mixed member anti-avoidance legislation in April 2014 curtailed the level of retained profit removing the original benefits that a mixed partnership provided.

Does incorporation have other implications?

Following the introduction of the above mixed member legislation and other anti-avoidance measures such as salaried member legislation, the appetite for mixed membership LLPs reduced and the focus moved back to full incorporation (which in most circumstances can be achieved without any tax leakage) or alternatively “hybrid structures”.

Full incorporation certainly meets most if not all the commercial challenges outlined above, but the formation of such structures does have significant commercial, legal and taxation implications which need to be considered and structured very carefully:

  • Inflexibility of shareholdings for succession planning
  • Capital gains mitigation
  • VAT and achieving zero tax leakage
  • Profit extraction with dividends
  • Rewarding key employees through share schemes and share options
  • Employment related securities.

Something else to consider

Despite the changes to the taxation of LLPs and continued attention of the Government, an LLP  provides a flexible structure to facilitate inter-generational changes in membership.

However, there could be a new kid on the block – some professional service firms are taking advantage of the Employee Ownership Trusts (EOT) structure. EOT provides capital gains exemption on certain share disposals and a new tax exemption on qualifying bonus payments to employees.

Although popular in certain non-legal professional sectors only a handful of law firms have adopted this structure.  It provides an interesting alternative to the traditional business models, but we do not expect this structure to really challenge either the LLP or company for many years to come.

Mark Waddilove, Partner, RSM and Lewis Tompkins, Manager, RSM

Solicitors Group, April 2017