PM255680 - Disguised salary: profit share realistic view

ITTOIA/S863B (3)

In deciding whether or not something is a profit share, it is important to take a realistic view of the facts.

The legislation looks through terms that are unlikely to be triggered, and focuses on what happens in practice.

It is important to look at what happens rather than what something is called.

Slicing the cake:

One analogy that some people find helpful is to think of the profits of the overall business as a cake.

The question is whether what that individual receives is a slice of the cake. The proportion of that cake that the individual receives may depend on their own performance. However what the individual receives does vary in practice with the overall profits as the total amount of cake the individual receives depends both on the size of the slice and on the size of the cake.

If the firm has had a good year, then the cake is large and each slice is worth more.

If the firm has had a poor year, then the cake is smaller and the individual gets a bigger slice of a smaller cake. The amount received does vary with the profits and Condition A is not met.

Example 1

This example highlights that it is important to focus on whether, on a realistic view, the amount represents a share of the overall profits, so that the profit share that member gets will vary on the basis of the overall profits of the LLP.

In the ABC LLP, the profits are divided on the basis of units. Each year’s profits are allocated by dividing total profits by the number of units in issue to determine the value of a “unit”. There are no salaries, or guaranteed profits.

Each member’s profit share is calculated by reference to the profits and the number of units that they hold.

A is the senior member; he has been allocated units that reflect the time that he has been a member and the fact that he has the main client portfolio for the business.

R is semi-retired but has a large number of units, reflecting her equity investment in the business P is a junior member but has been allocated additional units because she has had an exceptionally successful year.

Q has only just joined the LLP. He has been allocated units that are expected to give him a profit of about 10% more than the salary he had been on as an employee. It is agreed that Q can draw a higher proportion of his expected profits share, in line with his “take home” as an employee, but he has no priority over the other members, and he is aware that in the event of a shortfall, he will have to repay the excess drawings.

All four are receiving profit shares, because the sum they receive is dependent upon the profits of the business. In other words, it is not:

varied without reference to the overall amount of the profits or losses of the limited liability partnership.

To illustrate this, consider how the share P receives may be affected by the profits of the LLP as a whole:

Due to a professional negligence claim, the value of a unit is much lower than last year. As a result, although P has had an exceptional year and has been allocated more points than last year, her share of the profit is £20,000 less than the previous year.

Although P may have more units than last year, what she receives is dependent upon the profits of the business as a whole. The LLP has not had a good year, so even though she has had an exceptionally good year, P actually gets less money than the previous year.

To use the cake analogy, P gets a bigger slice of a smaller cake. The amount P receives does vary with the profits and Condition A is not met.

Example 2

This example considers how the legislation takes account of a theoretical but practically irrelevant prospect of a profit share.

Four people decide to set up a cafe together. Members A, B & C do not have any capital to invest so only put in £100 each. The fourth, Member D, provides the funding for the venture.

They agree that Members A, B & C will each have a salary of £25,000 a year.

The agreement is that these are not repayable even if the profits are under £75,000 (and as such they are Disguised Salary).

Any loss would fall to Member D, who will receive the first £125,000 of profits after payment of salaries. Profits above that limit will be divided equally.

Members A, B & C all potentially have a share of the profits, the question is how realistic is that possibility?

For Members A, B & C to receive a variable profit share based on the overall profits of the LLP, the profits need to be in excess of £200,000. For Condition A not to be met, the profits would have to exceed £250,000.

If the business plan is based on an expectation of profits of between £100,000 and £150,000, then there is no reasonable expectation that the income of Members A, B & C will, in practice, be affected by the level of profits and Condition A is satisfied.