Feature

posted 12 Aug 2009 in Volume 3 Issue 6

Intelligent funding

A series of events over the past year have reignited the interest from law firms when considering the trading structure options available to them.

Historically, firms often told us that limited liability status was ‘not persuasive enough for them’ or ‘would create division in their partnership’. More recently, many firms have been sweeping those views aside faced with plummeting cash levels, higher threats of litigation from clients and the costs of redundancies and employee claims.

Future opportunities for external investment, together with the changing ethos in many firms towards managing boards that are often distinctly separate to the partners, are also playing a role in driving a review of firm trading-structures.

Impetus to revisit structures

Our experience has been that the following factors are proving instrumental in changing this view.

Proposed changes to income tax rates

The announcements in the 2009 Budget present a significant additional tax burden to many self-employed lawyers moving into 2009/2010 tax year onwards.

Table one (overleaf) indicates the extent of these changes and the planned marginal tax rates for individuals over the next few years. What this illustrates is that planning the absolute level of profit that an individual has in each tax year, as well as whether the profit is of a capital or income nature, will become more critical.

Firms will now be looking for trading structures that enable them to more closely control when profits are taxed and whether they are recognised as income or capital profits.

In traditional partnership and LLP model accounts, trading profits of the firm are automatically taxed in the year they are earned; potentially, in the future, at up to 51 per cent for income tax. In contrast, in a limited company, the immediate tax effect for corporation tax purposes may be only 22 per cent.

Table one also clearly illustrates that there will be a desire to create capital profits taxed at 18 per cent or less, as opposed to trading profits potentially taxed at up to 51.5 per cent at certain levels. It seems possible that there will be a closing of the differential in capital and trading profit tax rates, together with increased focus on anti-avoidance in this area. In the meantime, capital profits will be keenly sought.

Economic climate and drive for capital levels on firms

The rumours of capital calls in firms are a current feature of legal life in most areas of the country. Many firms have experienced a turbulent time over the past year, with the following delivering a serious hit to their cash flow position:

Downturn in interest on client funds, due to lower balances and lower base rates;
Increased incidences of bad debts and higher lock-up levels;
Short-term cost of staff redundancies;
Restrictions in the credit market;
Declines in property values on balance sheets and breaches of covenants with lenders; and,
Reduced underlying profitability.

The culmination of these events has led to capital calls of one kind or another in many firms over the past year; others have been delaying payments of prior year profits or pushing their borrowing limits to higher levels to hold off capital calls. Higher capital requirements have also caused firms to consider trading structures and, in particular in the case of personal capital calls from partners, where those funds will come from.

In many firms, a simple solution has been for partners to secure personal loans to invest in the business. In many cases, however, such loans are not available; banks will often look at the overall lending exposure the firm is exposed to, and credit market restrictions have made this more difficult to secure.

Retained profits in the business are often the next easiest and least controversial source for partners; however, in a partnership structure, such profits are automatically subject to income tax (in the future up to say 51 per cent), regardless of whether or not they are retained in the business.

Equally, personal cash injection from partner savings are, in many cases, likely to represent historic profits taken from the partnership business after income tax paid of, say, 41 per cent.

Accounting treatment of conditional fee agreement matters

In May 2009, the Accounting Standards Board issued a long-awaited clarification on the accounting treatment (the point at which income is recognised) in relation to conditional fee agreement (CFA) fees.

Without considering this issue in detail, the broad clarification was that for CFA matters where liability was proved at the balance sheet date, a best estimate of full recoverable value for fees should be recognised in the financial accounts and for tax purposes.

For other CFA matters, there is now an option to either recognise no asset/income at that point or to defer the costs incurred on such matters. Clearly, these options have significantly different results for both accounting and taxable profits in law firms.

This confirmation is significant to trading structures because it will prompt revisions to many firms’ recognition approach for income, for example, to ensure equity between partners joining and leaving the firm where CFA matters are a significant feature of the business.

This action will create a funding (capital) requirement in firms to fund earlier payments of tax and repayment of higher current-account balances to retiring partners.

Additional capital requirements create the need to consider how that capital is raised: retained profits, fresh capital injection from partners or external funding in the future. Ultimately, again, this stimulates a review of trading structures.

Alternative business structures and external investment

The Legal Services Act 2007 (LSA) presents opportunities for firms to attract investment to develop their businesses, which under a traditional professional partnership model has proved difficult to achieve with lawyer-owner investors alone.

The desire to access external investment will mean that trading structures will become more important in order to agree the mechanism by which third-party investment is actually made and how they wish to extract value. While it is likely that in most firms the core ownership of the business will still revolve around a partnership model, external ownership is more likely to be achieved through corporate membership of, say, an LLP rather than direct membership.

The tendency, at present, when considering external investment is to ignore the mass population of firms in the UK and focus only on the top-250 firms. However, there are a wide range of opportunities for small and medium-sized firms in the future and, in many ways, these businesses will be able to more readily access flexible trading-structures than larger firms due to their absolute size and less diverse ownership base.

Any development of strategic alliances between professional firms, for example, while technically possible already, may in the future be formalised by a change in structure whereby, say, an estate agent or firm of surveyors becomes a corporate member of the legal LLP to share profits on certain ventures. Investment management firms are another likely possibility for such arrangements.

Structural options

Having considered the above four areas, we appreciate why there is a renewed impetus to consider trading structures. We can briefly consider some structural options that are available and their relative merits. For firms considering these structures, the starting point should not be to consider what structures can be used, but what issues are particularly relevant to their business. The structure should then follow to help the business achieve its objectives.

It is only possible, here, to outline the core options and to introduce the subject. A starting assumption, which is simplistic, is that for most firms, their existing and future core trading structure is likely to be focused around an LLP or partnership model.

One of the consequences of each of the following structures is the introduction of the ability to reduce or defer tax liabilities on the income. Care will always be needed in the detailed structuring and management of any HMRC enquiries.

An LLP with a wholly-owned limited company subsidiary

The first point is to consider the circumstances under which this structure could arise. While not an exhaustive list, the following are common reasons to generate a trading subsidiary in this situation:

Transfer of its existing ring-fenced legal service(s) to the subsidiary;
New non legal/complementary service to develop a business offering;
Service company to the main LLP (possibly); and,
Joint venture with an investor.

However, while this structure can be achieved, firms need to have a clear understanding at the outset of why they are setting up such a structure and, more importantly, how they can exit in the future if the structure is no longer effective for whatever reason.

Predominately, the reasons for setting up a subsidiary in this way will often be a combination of the following factors:

Liability

Using a separate company vehicle clearly keeps those trading activities away from the main legal business. This may be due to the perceived higher risk of the activity, for example, and the desire to safeguard the assets of the LLP itself.

Capital

A primary driver may be the need to create more retained capital from profits within the business. Using a company vehicle may accelerate this retention of capital by transferring profits from the LLP to the company, which will retain profits after corporation tax of potentially 22 per cent rather than after income tax of up to 51 per cent in the LLP.

This route then leads a mechanism to supply accelerated funding to a potentially cash-hungry venture transferred to the subsidiary or a fund to lend to the LLP itself.

Tax

From a tax perspective, the opportunities presented by this method mainly relate to the timing of income tax being incurred by the ultimate members of the LLP or the ability to create capital gains.

In the case of income tax, the subsidiary presents the opportunity to time the release of profits to the LLP through dividends or management charges to ensure that the individual member’s personal income tax position is optimised over a number of years.

This will become a more attractive feature moving forward, taking into account the complexities and increased tax costs introduced by the 2009 Budget.

From a capital gains tax (CGT) perspective, there may be potential in the future to sell the shares in the company to a third party and create capital gains on disposal for members of the LLP.

Of course this sounds appealing, but there are complicating factors that need to be considered at the outset for firms looking to pursue this approach:

The cost of establishing the separate entity and the ongoing maintenance costs – understanding at an early stage whether the commercial benefits or tax savings are higher than the costs involved is crucial;

Retirement of members is important – in particular, how the value of any profits to which they would have otherwise been entitled, now to be held in the limited company, are released; and,

The risks and costs of creating a secondary regulated entity if the limited company undertaking reserved legal activities.

An LLP with a limited company member

In this situation, the limited company is one of the members of the core LLP that delivers legal services. Ownership of the company itself is immediately a consideration here.

There are many combinations that can be considered. Perhaps the simplest is that shares are held by the other members of the LLP only – potentially in the same proportions as profits earned by them as individual members of the LLP.

Alternatives may be partial ownership by a specific group of members (for example, full equity members only) or in the future, part or full external ownership by a third party as a mechanism to deliver funding to the LLP and take a share of profits on a joint venture. There are clearly many other permutations available here to deal with different commercial situations.

The core attributes of this approach are similar to those outlined in the case of a limited company subsidiary. Perhaps a more significant issue for this particular structure is considering the retirement arrangements of any LLP members who also own shares in the corporate member as well.

Factors to consider include:

Requirements to surrender shares on retirement;
Shareholder agreement terms and details;
Valuation methods on the disposal of shares; and,
Controlling dividend timing to meet the personal tax-planning needs of a diverse group of owners.

There are further opportunities to consider with such a structure; for example, on establishment, the potential ability to generate a capital gain on the sale of the right to future profits in the LLP. Although a one-off event, this may well provide the opportunity for profits that would otherwise have been recognised as trading profits in the LLP, potentially taxed at 51 per cent, to be recognised as a capital gain and taxed on the same individuals at ten per cent or less if both entrepreneurs relief and personal CGT annual allowances
are available.

An LLP with a separately owned limited company

This situation remains a further option for firms to consider and presents the same opportunities of hiving off potential higher-risk activities into a separate corporate vehicle.

In many ways, this arrangement achieves broadly the same effect as two previous options outlined. There are some subtle differences and this is certainly a structure that merits consideration at the planning stage of looking at alternative structures.

In summary

Current challenges and future opportunities in the legal sector mean that there is now potential for the intelligent use of trading structures to provide assistance for firms.

Andrew Allen is a legal sector partner at Winter Rule LLP Chartered Accountants. He can be contacted at aallen@winterrule.co.uk