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Stepping up from the ranks to become a full partner in a limited liability partnership (LLP) involves a fundamental change in status from employment to self-employment. The tax consequences of that shift came under analysis in an important Upper Tribunal (UT) decision.
The case concerned a clothing retailer which operated as an LLP and paid bonuses to its employees under a long-term incentive plan (LTIP) by reference to profits made over a period of time. After five employees were promoted to become full partners in the LLP, they received bonus payments under the LTIP.
HM Revenue and Customs (HMRC) took the view that those bonuses were earnings derived from employment and were thus subject to Class 1 primary and secondary National Insurance Contributions (NICs). The LLP considered that they represented profit distributions and fell to be taxed as self-employed earnings. The amount of NICs in issue was in the order of £1 million.
The First-tier Tribunal ruled in favour of HMRC, but the LLP appealed. It pointed out that the status of being a partner in an LLP is in general an absolute bar to receiving employment income from the LLP. The five received the bonuses in their capacity as partners, and not that of employees, in that their entitlement to payments under the LTIP only crystallised after they became partners.
Dismissing the appeal, however, the UT found that the five received their bonuses in their capacity as former employees of the LLP. Their contractual right to payments under the LTIP had been acquired when they were still employees and was not affected by the fact that they had become partners by the time the payments were made.
The bonuses were not paid solely by virtue of the five being partners in the LLP but by virtue of the fact that they had complied with all the conditions of the LTIP, a scheme that was only open to employees. The fact that their bonus entitlements did not crystallise prior to them becoming partners had no impact on their pre-existing contractual rights.
The UT acknowledged that Section 4(4) of the Limited Liability Partnerships Act 2000 precludes a member of an LLP from also being an employee of the partnership at the same time. However, a conclusion that the bonuses paid to the five were derived from their employment did not involve any finding that they were to be regarded as continuing to be employees. When the bonus payments were made, the five had two different relationships with the LLP, as partners and as former employees with subsisting contractual rights.