- What’s the difference between being employed and self-employed from a tax point of view?
- How are partners’ profit shares taxed in a partnership, LLP, or limited company?
- What is the most tax-efficient structure for a law firm?
- How are employee salaries taxed?
- What are the best opportunities to reduce the tax on the firm’s profits?
- What are the options for selling my law firm, or my interest in my law firm?
- If we sell the firm, how is the sale taxed?
- What are the rules on claiming tax relief on finance costs to buy a rental property?
- Can I claim tax relief on finance costs to buy into the practice?
- How can we use pension contributions to reduce tax?
- What’s the maximum amount I can pay into my pension?
- My pension contributions are capped, how else can I reduce my tax liability?
- What are the tax implications if the firm provides me with a car?
- What are the tax benefits of fully electric or hybrid vehicles?
- Can I use an ISA to save for a deposit on a house?
- As a partner, what personal expenses can I deduct from my taxable income?
- Can I offset expenses for working from home against my profits?
- What are overlap profits?
- What happens if I change my year end?
- What can I do to reduce my income to below £100,000 and retain my personal allowance?
- Should I claim child benefit if I am entitled to it even though I will have to pay it back?
- What happens to my private expenses if I incorporate?
- Can I bring my family into the company?
- Can I use the cycle to work scheme?
- What can I pay my employees for working at home?
- Can I buy a laptop through work?
- Can I get tax relief on my training expenses?
- How do I work out my private usage of motor expenses?
- What gifts can I make to reduce the value of my estate for IHT purposes?
- Following Brexit, should my law firm charge UK VAT on services supplied to an overseas client?
Karl Millward, a tax manager in the legal sector team at accountants Hazlewoods, answers common questions about tax from people working in law firms. (8 March 2021)
1. What’s the difference between being employed and self-employed from a tax point of view?
If you are employed you are taxed under the Pay As You Earn (PAYE) system. Tax and national insurance contributions are deducted from your gross pay at source every month.
Self-employment income is taxed via the annual self-assessment tax return. You are taxed on your profits for the accounts year ending in each tax year. For example, if you prepare accounts for the year ending 30 April 2021, these profits will be taxed in the tax year ending 5 April 2022 (2021/22). As a result, tax is often payable long after the profits were generated – 21 months after if you have a 30 April accounting date.
2. How are partners’ profit shares taxed in a partnership, LLP, or limited company?
In a partnership and LLP, partners (or members as they are known in an LLP) are taxed on their share of taxable profits, regardless of the amounts drawn out of the business.
Tax payments are made on 31 January and 31 July each year. Tax payments for the 2021/22 tax year are payable in three instalments: On 31 January 2022 (first payment on account [POA] based on 50% of the 2020/21 tax liability), 31 July 2022 (second 50% POA) and 31 January 2023 (a balancing payment – or repayment – for the tax you actually owe).
For a limited company, corporation tax is paid on the taxable profits of the business, at the prevailing rate. An employee or director is only taxed on the income they pay themselves from the business, usually in the form of salaries or dividends.
3. What is the most tax-efficient structure for a law firm?
There is no ‘one size fits all’ structure for a law firm, but depending on your circumstances, one type of operating structure may be preferable to another.
For most law firms, the choice lies between operating as a limited liability partnership (LLP) or through a limited company. Traditional partnerships are less common nowadays, due to partners having unlimited liability for the firm’s debts. From a tax point of view, there is no difference between an LLP and a traditional partnership.
If profits are retained in the business to fund investment, service debt or pay off former owners, a limited company may offer advantages, as profits retained in the business will generally be taxed at a lower rate through a company than in an LLP. Tax is not the only factor to consider though.
4. How are employee salaries taxed?
Employees are taxed under the Pay As You Earn (PAYE) system, with tax and national insurance contributions deducted at source.
Employees are given a tax code by HMRC, which determines the amount of tax to be deducted, and should ensure the allowances available are spread evenly throughout the year. The basic PAYE tax code gives an employee a tax-free personal allowance (£12,500 for 2020/21). If the employee has other earnings or benefits in kind, these can be incorporated into the code, so in theory the correct amount of tax is deducted at source.
5. What are the best opportunities to reduce the tax on the firm’s profits?
The key is to maximise tax relief on the expenses incurred, in order to reduce the firm’s taxable profit. One way to do this is by planning the timing of capital expenditure that attracts capital allowances to ensure that you qualify for the 100% annual investment allowance (AIA); this means that you get full tax relief on your capital expenditure in year 1.
The AIA was temporarily increased to £1,000,000 but the current plan is that it will revert back to £200,000 from 1 January 2022. If you are considering spending a lot of money on capital items, eg on a refurbishment, it may make sense to look at the timing of this and perhaps bring it forward.
6. What are the options for selling my law firm, or my interest in my law firm?
If you retire as a member of a limited liability partnership or a partner in a traditional partnership, and it continues in business afterwards, your interest will either pass to the remaining partners, to incoming partners, or perhaps to a combination of the two. Alternatively, the partnership might sell its trade and assets to another firm, after which the partnership would cease.
If you are a shareholder in a company, selling your interest in the firm will mean a sale of your shares. This could be achieved through a sale to other shareholders, to the company itself, to a holding company set up for the purpose of acquiring your shares, or to a third party.
7. If we sell the firm, how is the sale taxed?
In a partnership or LLP, your capital/current account will generally represent amounts that have already been taxed, in which case there will be no further tax to pay on those balances.
If, on the sale, a payment is received for property owned by the firm and/or goodwill, these assets are subject to capital gains tax, and you may have a tax liability on the amount received.
If you are a shareholder in a company, you will generally pay income tax or capital gains tax on the sale of your shares. Income tax will be usually payable if you sell your shares back to the company itself and the conditions for capital treatment are not met, or if you sell your shares for more than their market value. In all other situations, you will pay capital gains tax if you sell the shares at a gain.
8. What are the rules on claiming tax relief on finance costs to buy a rental property?
Since April 2017, tax relief has been gradually restricted to the basic rate of tax (20%) for mortgage loan interest and other finance costs used to buy a rental property. The rules are fully phased in from 2020/21, so now you will only get basic rate tax relief on these costs.
There are options to help mitigate the effects of these measures, including the use of property companies, or trusts, or simply bringing spouses into the property business.
9. Can I claim tax relief on finance costs to buy into the practice?
Any interest paid on a loan to buy into a practice can be offset against taxable profits on the individual partner’s tax return, and relief will be available at the individual’s marginal rate of tax. The incidental costs of obtaining the loan finance may also be claimed.
10. How can we use pension contributions to reduce tax?
Pension contributions can be an extremely tax efficient way to save for retirement. Normally, contributions are paid net, with the basic rate tax relief claimed by your pension company. For example, if you paid a contribution of £8,000 this would be added to your pension pot together with the basic rate tax relief of £2,000.
If you are a higher rate taxpayer, you can get an additional 20% tax relief by claiming it on your tax return. For a 40% taxpayer, the net cost to you would therefore be £6,000 – a payment of £8,000 less higher rate tax relief of £2,000.
11. What’s the maximum amount I can pay into my pension?
The standard annual allowance, which is the amount that can be paid while still getting tax relief, is £40,000 and has been for many years now.
But this annual allowance reduces if your adjusted income is more than £240,000 (including the pension contribution). After that, the annual allowance reduces at a rate of £1 for every £2 of income until it reaches a minimum level of £4,000 at a total taxable income level of £312,000 (or more).
In addition to the above, individuals may make use of unused pension contribution allowances for the previous three tax years, meaning that in certain cases the maximum contribution level can be as high as £160,000.
An individual's lifetime allowance for pension savings is limited to £1,073,100 for 2020/21 (£1.055 million for 2019/20).
The legislation relating to all of this is quite complicated, so specific advice needs to be taken before making any decisions.
12. My pension contributions are capped, how else can I reduce my tax liability?
If you are looking to invest, then subscribing for shares in a Venture Capital Trusts (VCTs), Enterprise Investment Schemes (EIS) and Seed Enterprise Investment Schemes (SEIS) are all methods of reducing your tax liability. All carry generous tax reliefs if the scheme conditions are satisfied. You do need to bear in mind though, this would be an investment into a company and as a result, there is an investment risk to weigh up against the possible tax savings.
Income tax relief is also available for cash donations to all UK registered charities and certain non-UK charitable organisations too.
Charitable donations in cash need to be made under Gift Aid and are paid after deduction of income tax at the basic rate. By way of example, if you are a 40% taxpayer and make a cash donation of £10,000, you will pay £10,000 to the charity, the charity will reclaim £2,500 from HMRC and you will claim a further £2,500 via your self-assessment tax return. The effect of this is that the cost to you will be £7,500, and the charity will receive £12,500.
13. What are the tax implications if the firm provides me with a car?
If you are an employee and a car is provided to you by your employer, then a benefit in kind arises, which is taxable on you. The tax payable is calculated by taking the list price of the car and applying a percentage (based on the CO2 emissions of the car, with lower emission cars having a lower percentage). The benefit will be calculated and reported on a P11D by your employer and the tax will be collected by an entry included in your PAYE code.
14. What are the tax benefits of fully electric or hybrid vehicles?
For 2020/21, there is no benefit in kind if you are an employee and your employer provides you with a company car that has zero emissions, ie a fully electric car. For 2021/22 the benefit in kind will be 1% of the list price. For 2022/23 it will be 2%.
For example, if the car had a list price of £50,000, the benefit you would be taxed on for 2020/21 would be nil. For 2021/22 it would be £500. And for 2022/23 It would be £1,000. For 2022/23, the tax on the benefit at 40% would be £400, so even after the rates have gone up in a couple of years’ time it will be extremely tax efficient to be provided with an electric car, rather than a traditional petrol or diesel car.
15. Can I use an ISA to save for a deposit on a house?
Saving using an ISA is a tax efficient way to reach your goal, as the income and/or gains within the ISA are tax free. If you are saving to buy a house then the ‘lifetime ISA’, which was introduced on 6 April 2017, means that up to £4,000 per annum can be deposited and the Government will add a 25% bonus (ie up to £1,000 per year). Anyone between the ages of 18 and 40 can open a lifetime ISA and contribute up to the age of 50. The money can be withdrawn at any point, but if this is before the age of 60, a 5% charge will apply and the Government bonus will be lost unless it is used as a deposit on a first home.
16. As a partner, what personal expenses can I deduct from my taxable income?
If you are a partner and incur expenses personally then you may be able to deduct these from your taxable profit share, provided you can show that they were incurred wholly and exclusively for business purposes. This does not mean that there cannot be a private element, but this will need to be excluded from the amount claimed.
The most common types of expenses we see are motor running costs (including fuel, insurance, repairs and any finance interest), an allowance for working from home, interest on loans used to introduce capital, and other items such as computers, books, subscriptions, stationery, and training courses, where these are paid personally and not reimbursed by the business.
17. Can I offset expenses for working from home against my profits?
Yes, if you are self-employed and work from home then you can claim expenses to offset against your taxable profits. You can either calculate what your bills are (electricity, gas, water rate, council tax, etc) and work out the proportion relating to business use, or you can claim the £6 per week that employees can claim, without having to keep any records.
18. What are overlap profits?
The tax payable for each year is calculated according to the profit earned in the accounting year ending in the relevant year of assessment. For a partnership or LLP with a 30 April accounting date, it will be assessed for the 2020/21 tax year on its profits for the year ended 30 April 2020.
Tax legislation works in such a way that individual partners are only ever assessable on 12 months of taxable profits in any tax year. However, in the first year a business is taxed on the profit from the start date to the end of the tax year. The second year’s charge is normally based on the profits of the accounting year ended in the second tax year. Part of that profit has already been taxed in the first tax year, creating what is known as ‘overlap profits’.
For example, where an individual joins a partnership on 1 May 2019 and its usual accounting date is 30 April, the profits for the period 1 May 2019 to 5 April 2020 are assessed on the new partner in 2019/20, and then profits for the year ended 30 April 2020 are assessed in the 2020/21 tax year, ie the first 11 months are taxed twice.
Overlap profits can only be utilised when an individual either leaves a partnership, or on a change of the accounting year end date.
19. What happens if I change my year end?
A change of accounting date is only permitted once every five years unless HMRC are satisfied that the change is for commercial reasons. A change of accounting date will not be recognised if the first accounting period to the new date exceeds 18 months. Tax will be computed using the old date until the rules are met.
A key tax issue to consider is ‘overlap profits’. These are profits that are taxed twice and arise in the first few years of the business commencing, a new partner joining an existing business, or on an accounting date change. Overlap profits are deducted from an individual’s final profit on retirement, or on a change of accounting date, so that over the life of the business profits are only taxed once.
The rules for a change of year end broadly ensure that 12 months’ profit is charged in each year. Generally, if accounts are made up to a date earlier in the tax year than the previous date, profits of 12 months to the new date will be charged and potentially additional overlap profits will be created. If it is later, more than 12 months would potentially be charged and so a proportion of overlap relief created in earlier years will be deducted.
20. What can I do to reduce my income to below £100,000 and retain my personal allowance?
If your net adjusted income (taxable income less pension contributions) is over £100,000, you potentially will lose your personal allowance. The personal allowance (£12,500 for the 2020/21 tax year) is the amount you do not have to pay tax on. Once your income goes over £100,000, the personal allowance is reduced by £1 for every £2 by which your income exceeds £100,000, giving an effective tax rate of 60% (+2% NIC if self-employed).
To reduce your net adjusted income, a pension contribution could be paid. This could give you an effective rate of tax relief of 60% on your gross contribution. Similarly, a gift aid payment to a charity would have the same effect.
For example, Amanda has taxable income for 2020/21 of £120,000. She makes regular pension contributions totalling £5,000 gross. Amanda’s net adjusted income is therefore £115,000 (£120,000 – £5,000).
As her income is more than £100,000, her personal allowance is reduced. The reduction is £7,500 (1/2 x (£115,000 – £100,000)), taking her personal allowance for 2020/21 to £5,000. In order to regain her full £12,500 personal allowance, Amanda could make a one-off pension contribution of £15,000 gross, reducing her net adjusted income to £100,000.
To ensure that your spouse’s personal allowance, basic rate band and dividend allowance are fully utilised you may want to consider transferring any income producing assets in your name to them, which would in turn reduce your taxable income.
21. Should I claim child benefit if I am entitled to it even though I will have to pay it back?
If your income is over £50,000, you may have to repay any child benefit received – known as the high income child benefit charge. The amount you pay back is 1% of the child benefit for every £100 you earn over £50,000.
For example, Kate and Lawrence have a baby. Kate is staying at home to look after the baby. Lawrence earns £51,000 a year. Because Lawrence earns more than £50,000, he has to pay extra tax to repay some of their Child Benefit.
His income is £1,000 over the £50,000 limit, so the amount he is required to pay back is 10% (£51,000 less £50,000 divided by 100 = 10%) of their Child Benefit of £20.70 per week. So, he pays back £107.64 for the year (£20.70 x 10% x 52).
Apart from the cashflow benefit there is an advantage to claiming child benefit, particularly if your income is around the £50-£60,000 level, as if you don’t claim it but then your income falls you could lose out on payments you are entitled to.
Claiming child benefits also helps you protect your state pension if you are home looking after the children and not paying any National Insurance, as you will get credits towards your state pension.
22. What happens to my private expenses if I incorporate?
The easiest way for private expenses to be reimbursed to you is to complete an expense claim and for the company to then transfer a payment to you for that amount. This does not go through payroll.
For any private expenses to be tax deductible for your company, and to avoid a benefit in kind on you personally, they must be incurred “wholly, exclusively and necessarily in the performance of the duties of the employment”. This is quite a difficult test to meet, and it often means that if a company pays anything that has a private element, a taxable benefit in kind will arise on the individual.
Typical expenses that you can claim for are professional subscriptions (as listed on the GOV.UK website), 45p per mile when using your own car to make business journeys and subsistence (within reason) when required to stay away for work.
There are complicated rules when it comes to expenses such as telephone lines and broadband costs. Your company should provide you with a work phone in the company name to avoid any additional personal tax being payable.
23. Can I bring my family into the company?
For smaller law firms, which already have the feel of a ‘family business’, it might be appropriate. For larger practices, it might be an unwelcome complication.
Transferring ownership of shares to a spouse or civil partner should not give rise to any tax issues, but transferring shares to other family members would require careful consideration to avoid any potential tax liabilities.
Minor children can own shares, but if they are received from a parent and the income received on the shares exceeds £100 each year, it will be taxed on the parent, and so could negate the benefit of making the transfer.
When considering any change in the ownership of a limited company, you should ensure it is not precluded by the company’s Articles of Association or Shareholders’ Agreement.
24. Can I use the cycle to work scheme?
The cycle to work scheme can only be used by an employee or director. Unfortunately, self-employed individuals cannot take part in this as it is operated under salary sacrifice schemes.
The cycle to work scheme gives employees access – through their employer – to both standard and electric bikes as well as cycling accessories, whilst spreading the cost over 12 months. There are tax breaks for both the employee and the employer.
25. What can I pay my employees for working at home?
If your employees regularly spend time working from home, from 6 April 2020 you can pay them £6 per week without any benefit in kind arising. The company is able to claim corporation tax relief on the amounts paid.
If you do not want to pay each employee, the individual can instead make a claim directly with HMRC. They will then get tax relief for this through their tax code.
26. Can I buy a laptop through work?
As a director, equipment that is necessary and essential for you to carry out your duties, eg a laptop, can be purchased and provided to you by the company. As long as there is minimal personal use it will not be treated as a ‘benefit in kind’ and you won’t have to pay personal tax on it. The equipment will belong to the company, which will receive corporation tax relief on the initial purchase.
A benefit in kind cannot apply to the self-employed, but the same principles apply in terms of it being necessary and essential to your role. The cost of the equipment is eligible as a business cost in computing your sole trade or partnership profits.
27. Can I get tax relief on my training expenses?
Training or courses that are designed to merely update existing expertise or knowledge are eligible for tax relief either by a company or an individual. Expenditure on a course that provides new expertise or knowledge is capital in nature, and therefore there is no tax relief available. A new qualification is seen to be within the definition of ‘new expertise’, and therefore treated as capital, which then means no tax relief.
28. How do I work out my private usage of motor expenses?
A limited company can pay a director or employee up to 45p per mile travelled for business purposes, eg travelling from the office to a client’s premises. If you choose to pay less than this, the director or employee can make a claim for the difference through self-assessment. If the company pays more than this, then the director or employee will need to declare this as extra earnings.
If you are self-employed, you should log all business miles travelled throughout the financial year (travel from your home to the firm’s offices does not qualify), and then calculate this as a percentage of the total miles your car has done over the same period. This percentage can then be applied to the motor running costs to calculate the business element. It is also acceptable to do a simple mileage claim as above.
29. What gifts can I make to reduce the value of my estate for IHT purposes?
For inheritance tax (IHT) purposes, you can give away £3,000 worth of gifts (money, or possessions to that value) each tax year – this is your annual exemption. You can also give:
- small gifts of up to £250 to any number of people
- up to £5,000 as a wedding gift (depending on how you are related to the couple)
- payments to help with family maintenance, including the transfer of a property on divorce
- gifts to UK registered charities (no limit)
- gifts to UK domiciled spouses (including civil partners), again with no limit
All of these gifts are exempt from IHT. Any other gifts in your lifetime are potentially IHT free unless you were to die within seven years of making the gift.
30. Following Brexit, should my law firm charge UK VAT on services supplied to an overseas client?
With effect from 1 January 2021, the answer is almost certainly “No”. For both business to business (‘B2B’) and business to consumer (‘B2C’) supplies to an overseas client (including any client in an EU member state), the place of supply for VAT purposes is where the recipient of the service belongs. So any such supply is outside the scope of UK VAT. However, any VAT incurred on costs associated with providing the service is still recoverable.
One exception to this is where the service is concerned with effecting legal alteration to premises and any other immovable property – such as dealing with the transfer of a title to, or the establishment or transfer of certain interests in, the property. In this case, the place of supply is where the property is located, so UK VAT will be chargeable if the relevant property is in the UK.