Pros and cons of incorporation

Incorporation of law firms as limited companies and limited liability partnerships, together with other discussions on trading structures, has been in the headlines for a number of years. Commercial issues ranging from funding working capital, to managing succession, risk management, and even the July budget with proposed changes to dividend tax rates have fuelled this debate.

An important issue for law firms to consider when addressing the question of structure is the medium- and long-term strategy of their business. In our experience, some firms have rushed to fully incorporate as a limited company, often for perceived short-term tax benefits, when it may have been more appropriate for the business to consider a mix of an overall LLP at its heart with partial incorporation of appropriate elements of the business.

In this article I explore:

• situations where a limited company can be effective for law firms as the core trading vehicle;
• practical problems that can arise when trading through a limited company; and
• the role mixed partnerships can play in modern law firm structures.

In recent years we have seen considerable growth in the number of law firms using a limited company as their core trading vehicle. In many cases, we believe those decisions have been made on the basis of short-term tax planning opportunities, which often have finite value and, more significantly, damage the longer-term commercial position of the firm.

That is not to say that limited companies do not have their place. Let us consider where such a structure can assist firms.

Where a firm is looking to retain profits to either invest in the business or reduce existing debt, then a limited company provides a significant cashflow benefit over a partnership. This is because profits can be retained after payment of corporation tax at, say, 20%, rather than after payment of income tax (and National Insurance (NI)), most typically of either 42% or 47% in a partnership structure. Cash is retained more quickly in a company scenario.

A key point here is that if a law firm has a policy of drawing out all (or most) of the profits it earns, then historically the total tax cost in a partnership is broadly the same as that experienced in a company. This analysis, however, crucially relies on the common approach in such circumstances of the company profits being extracted predominantly by dividends, plus a very low salary, for shareholders/fee-earners working in the business.

However, following the July budget the increased rates proposed for income tax on dividends mean that, even if the profits are mainly extracted by dividends, higher and additional rate income tax payers will now most likely suffer increased income tax costs compared with a partnership.

For a higher-rate taxpayer today they would incur a marginal rate of 42% in a partnership (including NI); extracted as dividends from a company this effective cost after corporation tax and income tax would be 46% (falling to 44% when the proposed corporation tax reductions take effect by 2020).

Furthermore, if the profits extracted from a company include a commercial salary for the shareholder’s role in the business, due to the costs of employer NI, a company could actually be even more expensive.

Profits in partnerships are automatically subject to income tax, regardless of whether the partner draws those profits out. In a company, while corporation tax is incurred automatically (at 20%), the owners of the company are only subject to income tax when they extract the profits (by either dividends or salary).

A company structure therefore provides a degree of control over when the owners suffer effective full tax on their earnings. This in turn enables owners to better plan their personal tax positions, and potentially avoid the very high rates of income tax, particularly around the threshold levels of £100,000 and £150,000. For a significant percentage of UK law firms, reported profits per equity partner hover around these thresholds, so this can be a very real issue for firms each financial year.

Incorporation from a partnership into a limited company presents the opportunity for the partners who have sold their business to their new company to effectively draw down their current, capital and tax reserve accounts for a period of time after incorporation, in the form of a ‘director’s loan account’.

Of course, these ‘loan’ monies are not taxable in the hands of the partners and in the meantime the company earns profits and pays corporation tax at 20%. So, in effect, the partners have an income tax ‘holiday’ during this period. This can provide a valuable one-off cash benefit to the law firm. We have seen a number of firms where this income tax cash holiday alone may well have staved off financial failure during the recession.

This ‘holiday’ does eventually end. When it does, the holiday hangover kicks in, and firms start to realise it can be left with an inflexible trading structure where tax costs could occasionally be higher by the time profits are extracted.

Firms can also realise at this point that all they have done in effect is take their retirement benefits early. When they come to retire from the company and most likely ‘sell’ their shares in some form, there will frequently be a retirement taxation charge in the form of capital gains tax that, of course, would not have arisen on retirement from a partnership (save in the case of, say, capital assets such as partnership property being disposed).

This can mean their retirement from the business will be more complicated and expensive, which can also present a commercial risk: that individuals do not then retire at the ‘right’ time for them or the business.

Drawbacks

Now we have looked at the primary benefits of the limited company structure – albeit with some of those benefits having negative flipsides – we will look at the key drawbacks.

Allocating profits between shareholders in a company is materially constrained by shareholdings. This is only not the case for dividend waivers and more exotic share capital structures – but these are increasingly attracting attention from HM Revenue & Customs (HMRC), and are cumbersome to manage on a day-to-day basis.

This means the ability to share profits between individuals in the traditional way of a partnership is difficult and potentially expensive, particularly if differentials are ultimately paid via PAYE as additional salary or bonuses in a limited company structure.

The shareholders working in the business need to be paid a salary. This incurs employer NI, which is a more expensive charge overall than NI incurred by self-employed individuals in a partnership or sole practitioner position.

Most company tax planning revolves around having low (often uncommercial) levels of salary for such individuals. Once a firm moves away from this and pays a market salary, the tax cost of extraction of profits quickly starts to exceed the partnership position.

Payment of uncommercial salaries in such scenarios continues to be a focus for HMRC. Commentators are increasingly anticipating more legislation to arise in this area to reduce tax loss to the Treasury.

Many firms also forget that even if they can support a mix of very low salaries and dividends at the outset for owners who incorporated the business, such planning fails for future incoming shareholders. That is to say, there is specific tax legislation that inhibits one’s ability to take an employee fee-earner on remuneration of, say, £70,000, and replace this after they have acquired shares in their employer company with a salary of (say) £10,000 and dividends of £60,000.

This therefore restricts any future potential NI savings available in the medium term in a company structure. By contrast, in a partnership, once the employee becomes a self-employed partner immediate savings arise in terms of net NI.

Succession is a crucial issue. The sector is ageing, and further pent-up demand for retirement arose upon the start of the recession, as falling profits and pension scheme values reduced the ability of people to retire. Meanwhile, younger lawyers are less focused on achieving partner status than previous generations. Add these two together, and it is clear that there will be an increasing shortage of funding and key management skills across the sector.

There are a number of reasons why succession is more complex for a law firm in a company situation than a partnership.

The need for incoming shareholders, who are usually employees immediately before and after purchase, to purchase shares at market value or suffer an income tax charge is a significant point. This immediately presents incoming employees with an effective obligation to pay inherent goodwill in the share price – an issue that rarely arises in a partnership scenario.

It should also be noted that it is usually more difficult to secure commercial borrowing to make the share purchase, and this can be another material hurdle for incoming owners. In contrast, joining a partnership and securing a partner capital loan to make an equivalent investment, in conjunction with a legal undertaking from the partnership itself, is a relatively straightforward procedure.

In summary, the entry of an employee into ownership of a company that employs them is a less flexible – and more complicated – process than an employee joining a partnership structure. Given the challenge of succession and, in particular, finding successors in the current legal landscape, this can be an extra burden to the process.

A seemingly minor, but often crucial, point for individual shareholders is that, post-incorporation, their income from the company will often consist of a small salary and large dividends.

We frequently find this can make it difficult for those owners personally to borrow funds outside the business; for instance, obtaining mortgages can be much more difficult, because the lender will find it hard to rely upon the dividend income stream as a source of income to support the affordability of repayments on the borrowing.

Using the structure

We often see a limited company used as the core trading structure in small law firms. There are a number of reasons for this, but they revolve around the fact that such businesses tend to have a different strategy on succession and profit extraction. Specifically, they are more likely than larger firms to be planning to close down and retain profits to draw on retirement.

Where larger law firms use a limited company as their core trading vehicle, this will often be for one of the following reasons:

• They are seeking to make major investment in the business through profit retention.
• They have suffered financial hardship and need to reduce debt  levels.
• They take the view that a company will improve their ‘commercial culture’.

Mixed partnerships

Recent legislation relating to both mixed partnerships and self-employment status for partners has created some complicated issues for law firms to take into account when considering the mixed partnership route.

However, in our experience, many firms which do not choose the limited company as their core trading structure often still use a company within their arrangements in some form. This is to realise some of the structure’s benefits for an appropriate part of the business, without disrupting its core operations and creating some of the challenges noted above.

Three of the more common ways of involving a limited company in a firm’s trading structure are staff service companies, corporate partners (slow/long-term investment vehicles), or partial incorporation (reserved and non-reserved legal activities).

These structures are most commonly being used to:

• separate higher-risk work or higher lock-up work which can be funded more effectively in a company;
• provide the ability to control when income tax is incurred, particularly where profit levels hover around £100,000 or £150,000 on a regular basis; or
• achieve, in smaller firms, wider family tax planning, by spreading profits/returns between other family members.

The current review of the separate business rule by the Solicitors Regulation Authority, together with the background risks of dual regulation for law firms in respect of consumer credit arrangements, has further fuelled firms’ consideration of structures.

What should firms do?

Our advice to firms looking at their trading structure is to stick to some simple rules.

1. Consider your business objectives: Start by looking at the key objectives of your business and consider how each potential trading structure could contribute to achieving those objectives. Are your challenges succession-driven, growth-driven or simply driven by a need to reduce bank dependency?

2. Keep it commercial: Keep commercial arrangements and the reasons for your structure at the heart of your plans. This will help to give the structure greater longevity and reduce the risk of falling foul of both existing and future tax legislation.

3. Build in flexibility: Things change. Whether it is the business objectives or simply tax legislation, these factors can have a material impact on what constitutes a desirable trading structure. Building flexibility into any trading structure can be invaluable.

4. Communicate: Law firms consist of articulate and questioning individuals. In general, if they are presented with a trading structure that is unduly complicated, this leads to a lack of understanding, which quickly develops into cynicism and a lack of trust in the arrangements. To avoid these pitfalls, clearly explain the rationale for the trading structure, and establish it at a proportionate level.

5. Build clear entry and exit routes: Law firms are about people. Key people need to join and leave the business on a regular basis. For most firms, these include funders of the business, and the key skills and management of the business. Any structure needs to make entry and exit as seamless and effortless as possible. An early focus on these issues in any structural planning is crucial.

We continue to see the majority of law firms trading with a core partnership, primarily LLP, as their trading structure. The flexibility afforded by this structure is, in our view, what underpins its popularity. Furthermore, the fact that law firms pay out most of their profits to partners means that a company cannot offer any real benefit, from a taxation viewpoint, over a partnership.

Nevertheless, companies have their place. They remain attractive for very small firms, and can provide a life raft for firms under considerable financial strains.

However, their greatest long-term use, in our experience, continues to be as a peripheral part of a law firm’s trading structure: enabling firms in specific circumstances to access the benefits of a company without compromising the flexibility a partnership offers them in their core trading structure.

Andrew Allen is partner and head of legal sector at Francis Clark Chartered Accountants

• This article was first published in Managing for Success, magazine of the Law Society Law Management Section – the community for partners, leaders and practice managers in legal businesses. For more information about the Section and the benefits of being a member, see the website.