The budget and you: law firms and tax

The increase in national insurance (NI) and the reduction in dividend tax allowance will affect owners of law firms. And the theme developing from recent court cases is that it could become more difficult to run a practice that is often capacity driven with flexibility the key.

National insurance

The chancellor seems to assume that those people who are self-employed simply carry out their business that way to receive beneficial treatment in respect of the taxation of dividend income or the rate of NI they pay on their profits but these are actually, especially in the legal sector, real businesses employing thousands of people.

Those businesses are therefore paying employers’ NI, charging VAT, paying corporation tax and, if they are doing well and highly profitable, paying the higher rates of income tax. Many people who run law firms are entrepreneurial although at times the sector does not quite come across as that. They are at the forefront of AI in many guises but cannot via their partnerships and sole-trader status benefit from any research and development tax break so, once again, that piece of legislation is against them.

Those law firm partners who are self-employed and employ a number of staff will see this as another albeit very minor hit, on top of the addition of auto-enrolment increasing percentages: this is businesses taking the burden of pension provisions, to some extent, away from government in future generations. They will see their ‘thanks’ for this as the chancellor’s spring budget announcements.

To those higher earners, owners of profitable practices, the increase will not register greatly. Given the positive is the abolition of class-2 payments, the increase in class 4 (up 1% from April 2018 and 2% from April 2019 on profits up to the basic-rate band) is insignificant but will appear an indication of the government targeting these entities as easy wins – all lawyers have too much cash, obviously. Well Joe Public probably thinks so; as I say, an easy win.

Limited companies

With huge numbers of law firms having incorporated, the announced reduction in dividend tax allowance from £5,000 to £2,000 only increases their tax liability by £225 per annum but when you add last year’s tax increase of 7.5% on dividend income at all levels this is painful. The chancellor stopped short of doing anything further on corporation tax, which is planned to be fair to decrease to 17% by 2020.

Corporation tax was mentioned several times in the chancellor’s statement and this is probably because the government is considering using it as part of Brexit negotiations. Brexit will have an impact on many law firms, certainly not all negative but the need to have some kind of certainty is absolutely gold dust at present, so tax hikes are unwelcome where future planning is concerned.

Some firms will have contingency plans in place for how Brexit, hard or soft, could impact so in the interests of ‘fairness’ (the chancellor’s words) care needs to be taken to ensure that self-employed workers are not unduly disadvantaged. For this reason, the consultation announced to take place this summer is welcome. In particular, employers will also need to be reassured that they will still have access to this valuable and flexible employment pool. Again, where any business is uncertain about capacity requirements (perhaps due to Brexit uncertainties), this flexibility is very welcome rather than being some kind of tax dodge.

Employed vs self-employed – a theme at present

Whilst I am not suggesting any collusion, in line with recent court cases concerning Uber and Pimlico Plumbers, there seems to be a shift by government and the courts to encourage people to adopt employed rather than self-employed status. As I say above, long-term pension benefits for all is a worthwhile aim but let’s not make doing business too difficult in the meantime.

Legal profession does not help itself, but receives little encouragement

Law firms haven’t always helped themselves on profit retention and there is absolutely a wish to draw out everything they earn rather than building up capital value and retaining working capital for future projects; and these added tax hits will hardly encourage retention. The mindset and behaviours need to change but where are the incentives? Incorporation was a sensible route to aid a retention policy but the increased dividend tax makes that it more expensive for firms to keep their net income at the same level.

Unfortunately the lauded Enterprise Management Incentive Scheme to attract, retain and motivate talent is not available to law firms, and when LLPs look to bring partners in gradually via fixed-profit shares that was then deemed a tax dodge also a couple of years ago. Whilst that brought capital in to firms, did that get used for the long-term good in many firms?

Business rates

It was good to see that the government has listened to some extent and whilst this is welcome, it is still our view that this does not go far enough with the cocktail mix of rising inflation from the devaluation of the pound (increasing input costs for firms and reducing the purchasing power of customers), the apprenticeship levy, auto-enrolment, and the business rates revaluation all having impacts at a similar time.

With the current uncertainty encircling the economy from the impending Brexit negotiations and the continent all too willing to try and lure our high-performing business services sector across the channel, the chancellor should be doing all he can to encourage business and safeguard our prized asset. In our opinion, this might mean a root and branch review of whether business rates remain fit for purpose in our 21^st-century economy as they disproportionately impact the SMEs which are the lifeblood of the economy.

Peter Noyce is a business services partner at Menzies LLP and author of Brighter Thinking For Law Firms