How to convert from an LLP structure to a corporate structure

With the changes in the UK partnership tax rules which apply as from 5th April 2014, many businesses which are currently organised as LLPs are reviewing their legal structure. This is particularly the case in the fund management industry, where until now, LLPs have been one of the preferred legal forms for the advisory entity.

The new tax rules treat certain members of LLPs as if they were employees for tax purposes. For many businesses, this undermines one of the key reasons for choosing an LLP structure in the first place: the saving in employers’ National Insurance Contributions which could previously be achieved through individuals being treated as self-employed members rather than employees.

The new tax rules also have a particular impact for so-called “hybrid” structures where the main trading entity is an LLP, and the members of that LLP include one or more companies as well as senior members of staff. The new rules will restrict how profits of the LLP can be allocated to those corporate members, which was previously a way to retain profits in the business more efficiently.

So how can you convert, and what are the key considerations from a legal perspective?

Well, the options will obviously depend on what your current situation is and on the tax analysis involved. This article sets out two basic scenarios, and a possible route converting to a “pure” corporate structure for each of them. It also explains two potential commercial motivations to convert to a corporate structure, which apply irrespective of the tax issues.

Possible steps to convert from an LLP to a corporate structure

Scenario 1: The LLP has a corporate member which is entitled to all capital profits and all surplus assets on a winding up, with individual members having rights to income only

This type of structure is common for UK fund managers which are controlled by an overseas parent.

Possible legal steps for Scenario 1:

1. The LLP transfers its business and assets to the corporate member by way of a distribution in kind.
2. The individual members of the LLP resign or waive their right to receive remuneration from the LLP, conditional on entering into new employment contracts with the corporate member. (Some individual members will need to remain in place in addition to the corporate member, so that the LLP still has at least two members and can fulfill its regulated functions.)
3. If the LLP is FCA authorised, it can provide regulated services to the corporate member under a transitional services agreement for an interim period. Under those arrangements, the corporate member carries the risk and the benefit of the business as a whole, but the LLP continues to perform regulated functions such as that of fund operator.
4. Once the corporate member has obtained the necessary FCA permissions, the LLP can be dissolved.

Key legal feasibility issues for Scenario 1:

1. Member consents to transfer the LLP’s business and assets and wind up the LLP: Check the LLP agreement and related documents to confirm what level of voting consent on the part of the individual members will be required (e.g. no consent required / individual veto rights / simple majority / 75% consent / unanimity).
2. Solvency of LLP: Check that the LLP will remain solvent after the transfer (note that the corporate member may agree to assume liabilities of the business as a term of the transfer).
3. Consents by individual LLP members to their change in employment status: In order to carry out this proposal, any individual LLP members who become employees of the corporate member would need to do so voluntarily. As part of the arrangements to bring those people on board, you will need to consider what the ‘back stop’ position would be if an individual member did not consent, including the relevant termination provisions under the LLP agreement.
4. Carried interest and other incentive structures: Check what impact the proposed arrangements may have on any carried interest and other remuneration structures, and whether any changes will be needed. Consider also the position of potential ‘leavers’ who do not consent to becoming employees of the corporate member.
5. Transfer of other employees: Non-member employees of the LLP are likely to transfer to the corporate member under the Transfer of Undertakings (Protection of Employment) Regulations 2006 (TUPE). Check what requirements to inform and consult will apply.
6. Subcontracting and novation of fund management/ asset management agreements: Check what consents will be required, both for the interim subcontracting arrangements and for the ultimate novation of agreements to the corporate member.
7. FCA approval of corporate member: This is likely to take a number of months. You will need to decide whether to replicate the existing governance structure of the LLP for regulatory purposes (which may speed up the application), or whether changes will be needed.
8. Other third party consents and licences: Check what other consents and licences may be required in order to give effect to the proposed arrangements. These may include data protection registrations, consents from landlords in relation to leasehold premises, and consents by JV partners or other commercial counterparties.

Scenario 2: LLP with individual equity and non-equity members

In this scenario, the LLP may have some individual members who have an “equity’ interest in the business, and others whose only entitlement is to receive a specified share of the income profits. The LLP may also have a one or more corporate members.

Possible legal steps for Scenario 2:

1. Establish a new company (“Newco”) whose shares are owned by the equity members of the LLP. A new shareholders agreement and articles of association will be required.
2. The LLP sells its business and assets to Newco. The consideration for the sale is satisfied by the issue of loan notes in Newco.
3. The individual members of the LLP resign or waive their right to receive remuneration from the LLP, conditional on entering into new employment contracts with Newco. (Some individual members will need to remain in place in addition to the corporate member, so that the LLP still has at least two members and can fulfill its regulated functions.)
4. The loan notes are transferred to the equity members of the LLP as a distribution in kind, in accordance with their respective entitlements to receive capital profits or surplus assets in a winding up.
5. If the LLP is FCA authorised, it can provide regulated services to Newco under a transitional services agreement for an interim period. Under those arrangements, Newco carries the risk and the benefit of the business as a whole, but the LLP continues to perform regulated functions such as that of fund operator.
6. Once Newco has obtained the necessary FCA permissions, the LLP can be dissolved.

Key legal feasibility issues for Scenario 2:

The key legal issues here are very similar to those for Scenario 1. For ease of reference, they are set out in full.

1. Member consents to sell the LLP’s business, distribute the loan notes and wind up the LLP: Check the LLP agreement to confirm what level of voting consent on the part of the individual members will be required (e.g. no consent required / individual veto rights / simple majority / 75% consent / unanimity).
2. Solvency of LLP: Check that the LLP will remain solvent after the transfer (note that Newco may agree to assume liabilities of the business as a term of the transfer).
3. Consents by individual LLP members to a change in employment status: In order to carry out this proposal, any individual LLP members who become employees of Newco would need to do so voluntarily. As part of the arrangements to bring those people on board, you will need to consider what the ‘back stop’ position would be if an individual member did not consent, including the relevant termination provisions under the LLP agreement.
4. Carried interest and other incentive structures: Check what impact the proposed arrangements may have on any carried interest and other incentive structures, and whether any changes would be needed. Consider also the position of potential ‘leavers’ who do not consent to becoming employees of Newco.
5. Transfer of other employees: Non-member employees of the LLP are likely to transfer to Newco under TUPE. Check what requirements to inform and consult will apply.
6. Subcontracting and novation of fund management/ asset management agreements: Check what consents would be required, both for the interim subcontracting arrangements and for the ultimate novation of agreements to the corporate member.
7. FCA approval of Newco: This is likely to take a number of months. You will need to decide whether to replicate the existing governance structure of the LLP for regulatory purposes (which may speed up the application), or whether changes will be needed.
8. Other third party consents and licences: Check what other consents and licences may be required in order to give effect to the proposed arrangements. These may include data protection registrations, consents from landlords in relation to leasehold premises, and consents by JV partners or other commercial counterparties.

In any conversion from an LLP to limited company detailed and specific consideration should be given to the tax implications for the members, employees and entities involved. The scenarios described provide for potential tax benefits subject to overriding commercial purpose and careful navigation of anti-avoidance legislation.

Commercial reasons to convert to from LLP to corporate structure

Although the imminent changes in tax law may provide a spur to act now, in reality fund managers will be unlikely to go ahead with such a fundamental change in structure unless there are meaningful commercial reasons to do so. In this context, LLPs have two drawbacks which often form part of the reasons to convert to a corporate structure: the personal liability risks of members, and difficulties in structuring deferred remuneration.

(a) Personal liability risks of members

The risk profile of a member of an LLP is not the same as that of an employee, director and shareholder of a company. In particular, a potential ‘clawback’ applies to the members of an LLP which goes into insolvent liquidation: any amounts withdrawn by a member of an LLP in the two years before the commencement of the winding up of the LLP can be clawed back by the liquidator if the member receiving the withdrawal knew or ought to have concluded that, after that withdrawal and any other withdrawals in contemplation at the time, the LLP was unable to pay its debts and there was no reasonable prospect of the LLP being able to avoid an insolvent liquidation. (For these purposes “withdrawals” has a very wide meaning and would include normal monthly drawings, any distributions of surplus profits and any repayments of loans or capital to members).

(b) Difficulties in structuring deferred remuneration

Another disadvantage of LLPs is that it can be more difficult to structure deferred remuneration for members. This is because all of the profits of an LLP in each year must be allocated to its members for tax purposes, even if the actual receipt of that allocation may be deferred and subject to forfeiture at a later date.

The deferral of remuneration one of the key elements of the Remuneration Code for Alternative Investment Fund Managers – this is to align the interests of individual fund managers with the long-term interests of investors. Managers who are not within the scope of the AIFM Directive may want to adopt similar policies in order to demonstrate to fund investors that they are complying with best practice.

The difficulties in structuring deferred remuneration through LLPs is therefore very live issue for fund managers, and may form part of the motivation to move to a corporate structure, quite apart from tax issues.

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