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Business Tax  •  Personal tax  •  Tax Planning

Flexibility of an LLP can be better than the tax advantages of incorporation

By RJP LLP on 25 April, 2013

One of the oldest adages in the world of tax is ‘never let the tax tail wag the commercial dog’ and we hear it repeated time and again. No one likes to pay high taxes but being seduced by the prospect of lower tax should never cloud one’s judgement and become the sole justification for a business decision.

When making tax planning decisions there are many factors to consider, not least of which is the long term consequence of a particular action. Today’s tax policies may have changed in two or three years’ time and reversing a decision can be costly. In some instances, flexibility can be the most important consideration for a business, even if it means paying slightly higher taxes; this issue often lies at the heart of deciding which business structure to adopt.

In this blog we examine the pros and cons of two structural options for business owners requiring limited liability; we look at the commercial flexibility of limited liability partnerships (LLPs) compared with the tax advantages of limited companies.

LLPs have been available for over a decade now and are particularly popular as a legal entity for professional service firms such as solicitors, accountants and quantity surveyors. This is broadly because of the commercial flexibility they offer to owners.

However, whilst LLPs offer greater flexibility than limited companies in a number of ways, they tend to be less tax efficient. But in spite of this, they remain the entity of choice for professional service firms.

One reason for this preference stems from the traditional hierarchy found within these kinds of firms with the most senior individuals being appointed partners often creating a high level of fluidity at the top, with partners moving around within their industry to different firms as they progress through their careers and specialisations.

Having access to the informality and flexibility offered by an LLP, whereby partners can be appointed and leave with no capital changing hands, and no tax implications arising despite entitlement to a profit share, is often a very attractive and compelling reason for adopting LLP structure, even though it is less tax efficient.  LLPs are also considerably more flexible than limited companies in the way profits can be allocated between partners year on year.

Limited company structure on the other hand, offers the flexibility to shelter profits from the highest rates of income tax, which can have significant tax savings. It does also however create a tax environment whereby incoming shareholders must either pay market value for the shares they acquire, or  income tax on that market value. In addition to attracting a tax liability therefore, changes in shareholders can also mean entering into often lengthy negotiations with HM Revenue & Customs in order to reach agreement over the market value of the shares.

Whilst these are the obvious reasons why professional partnerships often prefer to use LLP rather than limited company structures, it is not the whole story, because of course the issues outlined do not apply to all professional partnerships. It may simply be the case that LLPs are the accepted trading structure for the industries concerned, and as a result, business owners often do not consider the tax advantages associated with transferring their business into a limited company. Perhaps now is a good time to consider them!

In summary: pros and cons of LLPs vs Limited Companies

Key considerations when forming a limited company

  • Corporation tax is payable on all profits. At 20% - 23% this is considerably lower than the top rates of income tax and NICs, and can be useful for maximising profits to be used for business cashflow;
  • Shareholders may take dividends on company profits and to the extent these fall within their basic rate band, they do not attract any additional income tax;
  • Dividends can be voted at different rates on different classes of shares;
  • The shareholders’ agreement can cover the position on an employee shareholder leaving the company;
  • Incoming shareholders are required to pay market value for the shares they acquire, or to pay income tax on that value;
  • Limited companies can be dissolved and it may be possible to utilise disincorporation relief and avoid incurring further taxes.
  • On transferring the business of an LLP into a limited company, the market value of that business provides an opportunity for large tax savings using entrepreneurs’ relief.

Key considerations when forming an LLP

  • Income tax plus national insurance contributions are payable by partners on their share of profits as they arise. The highest rate of income tax is currently 45%;
  • All profits are charged to tax in this way regardless of whether they are distributed or retained within the LLP;
  • Partners profits are not subject to employers’ national insurance contributions;
  • Partners’ share of any trading losses can be offset against their other income up to a maximum value of £50,000;
  • LLPs offer flexibility to alter partners’ profit sharing ratios and to introduce/remove partners.

The choice of whether to trade as a limited company or an LLP is specific to the particular circumstances of each case and should be carefully evaluated. Making a carefully evaluated decision can have significant tax benefits; but tax benefits should not be regarded as the most important factor. For professional services firms especially, flexibility can be key.

For more information on setting up a new legal entity for your business and the potential tax implications, please contact Lesley Stalker by emailing las@rjp.co.uk.

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