Law firms face steep tax hike

Many partners have been given another reason to dread the coming tax year, with Danny Alexander announcing yet another crackdown on partnerships and LLPs. The target this time: the use of service companies, beloved of many law firms.

Service company arrangements involve a firm’s placing many of its assets, including its staff, in a separate wholly-owned subsidiary. The service company then charges the firm for supplying those assets back to the firm. The tax saving arises because of transfer pricing rules, which apply to the charges that can be levied between members of the same group.  Under those rules, which were designed to stop companies arbitrarily moving profits around a group, it will be assumed for tax purposes that the service company has charged an arm’s-length price for providing the services. The result of this assumption is that the service company’s taxable profits are increased. The partners can make a claim so that the taxable profits of the firm’s partners are reduced by the same amount. The change in the rules will remove the ability of the partners to claim a reduction in their profits for the uplift in the profits of the service company.

Service company arrangements are relatively cheap to set up and have offered a small tax saving for many firms, particularly in respect of salary costs. Law firms have been attracted to such arrangements because they typically have large numbers of highly paid employees. Firms using service companies will now need to consider whether to continue to their use, whether to bring those assets back within the main firm, or perhaps to convert the entire business into a limited company.

On its own, this particular change, although unwelcome, will ultimately be more an inconvenience than a game-changing event.  But the move comes at a time when partnerships and LLPs are facing challenges on many fronts to their business models. In addition to the ongoing challenges of downward pressure on fees, legal aid changes, non-lawyer market-entrants and the ever-increasing cost and burden of regulation, law firms which operate as partnerships and LLPs (which are by far in the majority) are also being challenged by the government’s stated plans to impose employee taxes on certain types of partner and to restrict the tax benefits to be achieved by the use of limited companies in LLP and partnership group structures.

There is a remarkable contrast between the government’s approach to the taxation of companies and of partnerships and LLPs, with corporation tax rates being aggressively cut each year while partnerships and LLPs are being looked to as sources of increased tax revenue. The underlying issue is the ongoing disparity between corporation tax rates and personal tax rates, which the government seems unlikely to address in the foreseeable future. In the US, firms can elect to be taxed at the entity level or at the owner level and English firms may come to be jealous of that choice.

Even with the present uncertainty surrounding the degree to which firms will be affected by the forthcoming tax changes, the flexibility of partnerships and LLPs remains attractive. For firms accustomed to this flexibility, companies can present serious administrative issues, particularly when dealing with the thorny questions of repurchasing the shares of departing shareholders and varying profit sharing on an individual basis from year to year.  Some of these challenges can be overcome in the company context through careful drafting and administration, but this becomes a balancing act between increased administrative costs and potentially increased taxation.

The cumulative effect of the various tax proposals will mean that some firms will face a very large increase in their tax bill.  Firms with a corporate partner, a service company and a large rank of junior partners are most at risk. For such firms, the only way to mitigate the impact of these changes may be to fundamentally review their partnership structure. But no matter what steps are taken, some firms will unavoidably suffer more tax as a result of what is proposed. For firms already struggling to survive in this harsh economic climate, will this be the straw that breaks the camel’s back?

Tina Williams is a partner in the Partnership Group at Fox Williams