Service Company / Corporate Partner structures for Law Firms

The following note sets out the advantages, disadvantages and commercial points to consider when contemplating whether a legal practice should undertake a partial incorporation by using a service company or corporate partner within an existing structure. Some suggestions will be subject to restriction by the Solicitors Regulation Authority, the firm’s regulatory body, and therefore separate advice in this respect will need to be obtained.

Service Company
A service company can be used for the employment and provision of both support and professional staff along with entertaining and marketing services to the partnership at cost plus a suitable mark up.

The profits thus arising in the service company will be subject to lower corporation tax rates at 20% on the first £300,000 and a marginal rate of 27.5% on the balance, with a main rate of 26%. When compared with the equivalent income tax and national insurance rate of 52% from 6 April 2011 on the same profits if earned in the partnership, the attraction becomes all too clear. These tax and NIC savings enable the increased net profit after tax to be used in a variety of ways.

Accumulated profits can be used either to purchase assets used in the partnership’s business (and then made available to the partnership for a further fee), or to provide working capital to the firm. Given that one of the largest requirements of working capital is staff cost, (and perhaps rent payable under the lease) the company would be bearing the heaviest costs of running the business in a lower tax environment.

Surplus funds in the company could be used to pay retirement benefits to the partners, or used to incur entertaining or other tax disallowable expenditure. Such expenditure is of course disallowable for both income tax and corporation tax purposes so will be subject to a lower taxation charge if funded by the company because of the lower corporate tax rates involved. For the same reason, surplus profits could also be used to fund leasehold improvement expenditure which does not qualify for capital allowances.

Whilst some have expressed the view that s455 CTA 2010 (the legislation relating to loans to participators) does not apply to corporate loans made to a parallel LLP because an LLP is an entity distinct and separate from its members, this is not a view universally shared. Certainly HMRC contend that as an LLP is transparent for tax purposes and thus is treated as if it were a general partnership, the original rules do apply in such circumstances and so it must be assumed that loans will be caught under this legislation.

Therefore if the increased net profit retained in the company were to be used to service bank debt on behalf of the partnership or fund the expenditure of a general partnership or an LLP in some other way, (where the partners are the same persons as the shareholders in the company, or are connected with them for tax purposes) such amounts will be treated as loans to the individual partners / shareholders by the company. To the extent that such loans remain outstanding, a resulting liability under s455 CTA 2010 is almost certain to arise as well as there being a charge on the individual under s175 ITEPA 2003 where low or no interest is charged on the loan.

It is therefore to be recommended that no amounts due to the company by the LLP or general partnership are left outstanding at the year end and certainly not beyond nine months of the year end, and that the company issues timely invoices which are settled without undue delay by the partnership, and certainly within six months.

Commercially the use of a service company may present the partnership with a unique business opportunity in terms of outsourcing. This could involve the provision of legal professionals and back room support services to other smaller law firms who may not have the expertise and resource that your client has. Such a structure could also operate as a wider external consultancy, much in the same way as our own tax consultancy company operates. Additionally, a service company could be used to give director status to those employees not eligible, or not considered appropriate for, admission to the partnership as a partner or LLP member.

The shares in the service company can be held as a partnership asset and treatment as such will be useful from a capital gains tax viewpoint as generally HMRC will only regard the crystallisation of a capital gain as arising when a partner leaves or retires. The interest on any borrowings by individual partners to fund the company or to acquire shares in it will under current rules, qualify for income tax relief.  Additionally, a company and an LLP should be eligible to be in the same V.A.T. group.

HMRC also accept that the use of a service company is acceptable as long as any mark up is in the region of 5% therefore bigger numbers are required to make this worthwhile.

However, both the partnership and the service company may be subject to transfer pricing legislation as regards transactions between them (unless exempted as a medium sized enterprise (a MSE employs fewer than 250 people and has a turnover less than EUR €50m and / or a balance sheet total not exceeding EUR €43m)), so a more scientific arm’s length basis of charge may be necessary in these circumstances.

It should be noted that the creation of a service company will involve additional administration and cost. The company may require a full statutory audit and therefore may need to be accounted for separately. As for monthly management reporting, the results will need to be amalgamated in the overall reports to give a complete picture to the partners. There will be additional audit and tax fees costs to consider as well as the operation of company secretarial and company law matters.

The position of incoming and outgoing partners to the partnership and ownership of shares in the service company will also need to be considered.

Corporate partner
Another option available is the use of a corporate partner. The planning revolves around the appointment of a corporate partner to the partnership, the shareholders of which, are the existing partners in that partnership. Profits can be voted or allocated to the corporate partner, which can then be used as working capital for the partnership.

It is absolutely critical however that the corporate partner has a clearly defined role in the partnership. The company could be tasked with providing retirement benefits to partners or undertake the firms HR or Finance function. Whatever the role, it is crucial that there is a sound and credible commercial reason for its existence otherwise the structure will be left open to HMRC attack.

A corporate partner structure should be viewed as being more aggressive than the use of a service company.  However, unlike the position that relates to service companies, the provision of loans to the partnership by a corporate partner, or settlement of its liabilities should not be caught by s455 CTA 2010 or s175 ITEPA 2003. Therefore the increased net profit retained in the company (as a result of a lower taxation cost) can be used to settle partnership liabilities such as servicing partnership bank debt, potentially making such a structure highly tax efficient.

There is a view in some quarters that the allocation of profits to a corporate partner in this way can constitute a “settlement” and thus be ineffective for income tax purposes, and whilst a recent view by a leading QC is dismissive of such an argument, the matter is clearly not without some risk. It is also clear that a partnership containing a corporate partner does not qualify for the annual investment allowance for capital allowances purposes. Although the value of such an allowance is reducing in the future, careful consideration should be given to the loss of any allowance.

Information relating to the inclusion of a corporate partner within an LLP will be within the public domain and may not therefore be viewed as being “entirely straightforward” in the firm’s dealings with the public, public bodies or government departments, particularly where it may receive substantial profits. A disclosure in the accounts of an LLP may well be required if the corporate partner is the highest earning member of the LLP. However, on the plus side the use of a corporate partner might provide outside investment opportunities for Alternative Business Structures following implementation of the Legal Services Act.

Similarly, admission of a corporate partner will involve additional administration and cost. The company may require a full statutory audit and therefore may need to be accounted for separately. As for monthly management reporting, the results will need to be amalgamated in the overall reports to give a complete picture to the partners. There will be additional audit and tax fees costs to consider as well as the operation of company secretarial and company law matters.

Again similar to the position relating to service companies, the position of incoming and outgoing partners to the partnership and the ownership of shares in the corporate partner will also need to be considered.

Finally in either case Entrepreneurs’ Relief should be available on any future wind up of the company.  Whilst the former Extra Statutory Concession C16 is likely to be legislated, it will only apply where the company's distribution is (or total distributions are) £4,000 or less so a formal liquidation will almost certainly be necessary in these circumstances, adding to overall cost.