“This risks being a cutting off nose to spite face moment”

The Chancellor’s Autumn Statement on 23 November 2016 brought unwelcome news for anyone trading through a partnership or LLP, and especially for professional firms.

Profit-sharing

His statement to the effect, “Following consultation, the government will legislate to clarify and improve certain aspects of partnership taxation to ensure profit allocations to partners are fairly calculated for tax purposes,” is understood to refer to an intended proposal to the effect that partnerships and LLPs will be required to decide their profit-sharing arrangements at the beginning of a tax year rather than after the end.

If this is indeed the case, such a requirement would be a body blow for professional firms.

These days most professional firms of any size wait for the end of a financial year before conducting an in depth review of how a partner performed in that period, and then divide the profits for that period as equitably as possible in accordance with the outcome of that review. As well as taking into account personal and team billing, reviews often take into account contributions such as management, marketing, staff training and maintaining a knowledge base, which are essential to the success of any business, even though they cannot be measured in money.

So that model rewards performance in a particular period with a suitable share of profits of that period. Let’s call that Model 1.

In a variation of Model 1, after the end of a financial year some professional firms review the performance of each partner in that financial year in order to fix the percentage profit share of each partner for the following financial year. Let’s call that Model 2.

Even under Model 2, the fixing of profit share for a particular period does not take place before the beginning of that period, as the Chancellor may require.

Reduced incentives, reduced profits

Such profit-sharing schemes serve as powerful incentives to partners to achieve at the highest possible level. It is universally accepted that without such incentives most partners (like most human beings) will simply not go the extra mile.

The result is lacklustre performance and lacklustre (reduced) profits. And reduced profits impact ultimately on the public purse in the form of reduced tax receipts. The partnership sector makes an enormous contribution to the nation’s tax receipts. If the Chancellor decides to go ahead with these proposals in the form in which they are anticipated, he shouldn’t be surprised if there is a dip in tax receipts from this sector. This risks being a cutting off nose to spite face moment.

Every good managing partner knows that the best way to get partners (and other staff) to perform is to make sure they feel appreciated for their contribution. To a hard-working professional practices sector the Chancellor’s statement feels more like a bitter reproach.

The irony is that all partnership profits result in taxation in someone’s hands. The taxable profit pie might be divisible in many different ways, but at the end of the day, no matter how it is divided up, all of the pie bears tax. Leaving the division of profit until after the end of the financial year does not delay payment of tax or reduce the amount.

I have been a partner in professional firms, and have advised professional firms, for more years than I care to report, and I know that in the vast majority of firms profit share allocation has nothing to do with manipulating who pays how much tax. Rare “abuses” (as the Chancellor may see them) could be dealt with via tax avoidance legislation, rather than requiring an entire sector to alter healthy practices which have stood the test of time and produced greater tax revenue for successive Chancellors than would otherwise have been the case.

A possible solution for professional firms

If these measures go through in one form or another, professional firms are going to have to decide how to respond.

One possibility is to assess performance from half year (or three-quarter year) to the next. This would simply move the performance review period back three or six months, to allow time to carry out the review in sufficient time for the resulting profit shares for the following year to be worked out before the commencement of that year. Let’s call that Model 3.

This is workable but further divorces the performance from the reward. It also creates more work/admin cost for firms, again reducing profits.

Like Model 2, Model 3 produces a situation in which a partner may be rewarded for hard work in period 1, in which say there might be a very high level of profit. He is rewarded with a higher share of profits in year 2. But if profits in year 2 plummet, that results in the partner not getting a fair share of the year 1 profits, the very same profits that he had a major hand in generating. Outcome – delayed reward, incorrect reward, lower incentive, less future “extra mile” commitment, less future profit, less future tax.

Further news

Expect to hear more from the Chancellor on 5 December.

 

If you are affected by any of the issues raised in this post and would like a confidential, no obligation meeting or telephone discussion to explore how I can assist you, please contact me.

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