(Raul Arias)

Nonequity law
firm partners have become an endangered species in the United Kingdom, thanks to radical new tax rules for limited liability partnerships (LLPs). Law firms across the country—including the London offices of some top U.S. firms—are asking salaried partners to contribute equity for the first time as firms scramble to restructure their partnerships or face tax bills that could rise by millions of pounds per year.

Under the new Finance Bill, which takes effect on April 6, partners at U.K. LLPs who satisfy three criteria—including having little or no share in the firm’s equity—will be regarded as having a “disguised salary” and will be treated as employees for tax purposes [see "The Partner Test," below]. That means that firms would have to pay employers’ national insurance contribution for those partners at a rate of 13.8 percent of their gross salary—which for salaried partners in the U.K. often exceeds £200,000 ($335,000) per year—and would also have to finance the payment of monthly income tax. A senior partner at one U.K. top 30 firm says that a reclassification of its nonequity partners as employees would cost the business more than £1 million ($1.67 million) per month.

George Bull, head of the professional services group at U.K. accounting firm Baker Tilly, says that law firms are “caught in the crossfire” of legislation designed to crack down on LLPs that classify junior employees as partners to avoid tax. Such targets include some agricultural enterprises and hedge funds.

“[The U.K. government] realized that [the LLP structure] was being used by some firms to get around normal payroll obligations, but that was really a problem with the likes of temporary agricultural workers being made partners, not lawyers and accountants,” he says. “But something that started in a different corner of the playing field is now wreaking havoc in professional services. There are lots of unhappy people out there.”

Those unhappy people include partners at some of the largest U.S. firms. Several American firms have structured their London offices as U.K. LLPs—such as Baker & McKenzie, Mayer Brown, Reed Smith and White & Case—and thus are also affected by the new law.

“The whole way in which this legislation has been handled has been a complete shambles,” says the London office head at one leading U.S. firm subject to the rules, in comments similar to those voiced by five partners at other firms. The rules, he says, “were badly thought out and have been rushed through with minimal consultation. We won’t even know the final form of the regulations until after they come into effect.”

Firms are responding to the unpopular changes by tweaking their partnership structures to ensure that any salaried partners flunk at least one of the new law’s three tests for employee status. That’s not so easy. Under one test, a salaried partner can avoid being considered an employee if he or she has “significant influence over the affairs of the LLP.” Senior partners at three U.K. and U.S. firms say that they have received advice from accountants stating that a partner would need to sit on a global executive committee in order to meet that standard. “That’s utterly ridiculous,” says one U.S. firm partner.

Under another test, salaried partners can escape employee status if profit-related pay makes up at least 20 percent of their overall remuneration. But most firms say that adding a significant profit-related component to their salaried partner compensation systems is overly complex and unworkable in such a short time frame.

Firms are therefore mainly focusing on the third test by asking salaried partners for capital contributions equivalent to at least 25 percent of their annual pay. A spokesperson for Baker & McKenzie, which has more than 20 salaried partners in London, says that it is “reviewing current levels of capital contribution,” echoing comments by sources at the London offices of several other top U.K. and U.S. firms.

The Finance Bill states that any new capital contributions by partners would need to be financed from an external source. (Bizarrely, it also states that the additional funds cannot be used by firms to reduce their existing borrowings.) James Tsolakis, head of the legal services team at Royal Bank of Scotland, which provides banking services to around a third of U.K. law firms, says the bank has received more than 1,000 new loan requests as a result of the tax rule changes. RBS has had to pull in additional resources from other departments and offices to cope with the “easily tenfold” increase in activity, he adds. [Disclosure: RBS owns a minority stake in ALM Media, publisher of The American Lawyer.]

The U.K. government estimates that it will raise more than £3 billion ($5 billion) over the next five years in increased tax revenues from LLPs—a structure also common among accounting and financial services firms—as a result of the new law. But with each of the 11 firms interviewed saying they would be taking steps to ensure that their salaried partners continue to be taxed as partners, rather than employees, it seems unlikely that HM Revenue & Customs (HMRC) will see any significant swelling of its coffers from the legal industry.

“These changes will undoubtedly be disruptive to firms, but it is difficult to see what HMRC—or anyone—will really gain in the end,” says Gary Richards, chair of the tax committee of the Law Society, the representative body for attorneys in England and Wales. “The final result could well be unnecessarily over-capitalized firms and a negligible increase in tax from law firms.”

Although the controversial new law is likely to have its biggest effect on firms’ nonequity ranks, it could also spell the end of the guaranteed compensation packages often used by U.S. law firms in London to lure star lateral hires. Such fixed payments would qualify as a basic salary, potentially causing those high-earning partners to be taxed as employees. Just one partner on a guarantee of £1.5 million ($2.5 million) per year—the going rate for a top lateral in London, according to two recruiters—would raise the firm’s annual tax bill by more than £200,000 ($335,000).

HMRC said in a statement: “The [new law] is about fairness. There are anti-avoidance provisions within the new partnership tax rules, but the overall government objective is to protect tax revenue by removing unintended inconsistencies in the tax treatment across partnership types.”

The Partner Test

Under new tax regulations, partner in U.K. LLPs will be treated as employees for tax purposes if they meet three requirements:

1) They receive a fixed remuneration, or remuneration 
of which less than 20 percent varies depending on the overall profits or losses of the LLP. (HM Revenue & Customs refers to such compensation as a “disguised salary.”).

2) They do not have significant influence over 
the affairs of the LLP.

3) Their capital contribution to the LLP is less 
than 25 percent of their expected disguised salary for 
the whole tax year.