Determining whether a worker is employed or self-employed for tax purposes has long been a complex issue. This challenge has intensified in recent years due to tax regulations such as IR35 and Corporate Criminal Offence, as well as conflicting decisions from the Tax Tribunal and a shift in workforce dynamics, particularly with the increasing use of contingent workers.
The legal sector, which frequently engages non-employed consultants, faces specific tax challenges and risks. These issues are particularly problematic when it comes to HMRC audits or on corporate transaction due diligence. For law firms, two key risk areas are ex-partners and client-facing consultants.
In many traditional law firm partnership agreements, partners are required to retire at a set age—commonly 60 or 65.
However, the problem arises when partners are not ready to stop working at what is now considered a relatively young age to retire. Many feel they still have valuable contributions to make, and the firm, similarly, may be reluctant to lose long-standing partners, as their experience and client relationships are hard to replace.
As a result, former partners may be re-engaged as a self-employed consultant after retirement, often working reduced hours – an arrangement that is convenient for both parties (as it’s thought to be easier than changing the long-standing partnership agreement) but one that can complicate the tax classification.
For a worker to be considered self-employed in tax law, they must meet two fundamental criteria: independence from the business in which they are working, and be operating in business on their own account. These conditions are often difficult to demonstrate in the case of ex-partners, especially when they are still working within the same firm.
The key issues that create complications include:
In these situations, the law firm must prove the ex-partner’s consulting role is substantially different from when they were a legal partner. Furthermore, the firm must demonstrate the ex-partner is acting as an independent consultant when working for the business and that the terms under they are working are consistent with genuine self-employment.
Failure to adequately substantiate these distinctions could lead to HMRC challenging the ex-partner’s employment status for tax and National Insurance Contribution (NIC) purposes. Depending the specific areas of tax legislation that apply and on the contractual arrangements, this could result in the law firm being liable for PAYE, employer NIC, employee NIC (where due), interest and penalties. These liabilities can date back as far as six years, potentially resulting in a significant settlement to HMRC.
Another significant risk areas for law firms arises when consultants are hired in client-facing roles.
Whether the consultant is temporarily replacing someone on long-term leave or absence, increasing capacity during a busy period, or due to budget constraints, this arrangement could expose the firm to HMRC scrutiny and additional liabilities, and penalties if the consultant is paid off-payroll.
Given the complexity of employment tax law, each case must be considered individually. It can, however, be difficult to defend and evidence why such arrangements indicate self-employment, especially when applying the key ‘Employment Status Indicators’ used by HMRC and the Tax Tribunal as the scenarios below highlight.
In both of these scenarios, law firms must be cautious and ensure they can defend the self-employment status of their consultants.
Unless ex-partners or client-facing consultants are treated as employees and subject to payroll deductions, it is impossible to completely rule out the possibility of an HMRC challenge to their tax treatment, or for this to become a red flag during due diligence, where payments are made off-payroll.
However, not all such arrangements will necessarily be deemed employment for tax purposes. If the substance of the arrangement reflects a genuine, independent, consultancy relationship, it may be possible to defend the self-employment status. This would require solid evidence of the working relationship and alignment with the key ‘Employment Status Indicators’ and case law precedent.
That said, in our experience most ex-partner and client-facing consultants engagements within the sector lack many of the characteristics needed to classify them as self-employed under tax rules. This leaves law firms potentially exposed to significant financial and reputational risks if the consultants are paid off-payroll on a gross basis.