Partner capital loans for solicitors joining the equity

A partner's interest in a firm usually sits in two accounts. The capital account holds the money a partner has contributed to fund the firm's working capital, WIP, debtors and fixed assets. It is normally fixed and returned only when the partner leaves, often in instalments over a period set by the partnership or members' agreement. The current account receives each partner's share of profit and is drawn down through monthly drawings, less retentions for tax.

Firms set capital requirements in different ways: a fixed sum per partner, a sum tied to profit share or equity points, or a target ratio of capital to the firm's working capital needs. Firms with long lock-up generally ask for more capital, because partner money is funding the gap between work and cash. Capital is at risk: if the firm fails, it ranks behind the firm's creditors.

• Promotion to equity. The most common case: a salaried or fixed-share partner joins the equity and must pay in capital on day one or over an agreed build-up period.
• A lateral hire. A partner joining from another firm may have capital locked in the old firm, repayable over months or years, while the new firm wants its contribution now.
• Salaried members in an LLP. Members who might otherwise be taxed as employees can be required to contribute capital so that they fall outside HMRC's salaried member rules.
• Recapitalisation. A firm that has grown, taken on a lock-up-heavy practice area or been asked by its bank to strengthen its balance sheet may ask all partners to increase their capital.
• A merger. Partners joining an enlarged firm may need to equalise their capital with those of the other firm.

An LLP member is taxed as an employee if three conditions are all met. One of them, known as Condition C, is met where the member's capital contribution is less than 25% of their expected disguised salary, meaning fixed pay not linked to the firm's overall profits. A member who contributes at least that proportion falls outside the rules. HMRC's salaried member rules guidance sets out the tests, including anti-avoidance provisions aimed at contributions that are not genuinely at risk.

This matters for funding. A loan used to make the contribution can work, but the terms, including any arrangement for the firm to repay or indemnify the loan, need checking with the firm's tax adviser before signing. A lender will also want to know that the contribution is permanent capital rather than a short-term deposit.

A new equity partner or LLP member of an SRA-authorised firm is usually a manager, and sometimes an owner, of the firm and must be approved by the SRA before taking up the role. The SRA explains the process on its page on how to apply to add a manager or owner. Lenders funding a capital contribution may ask for confirmation that approval has been applied for or granted, so build that into the timetable for the partnership start date.

Consider a hypothetical illustration with deliberately round numbers. An associate promoted to equity is asked for £100,000 of capital and borrows it over five years. Her drawings replace her salary, but no tax is deducted at source any more. By her first 31 January as a partner she owes both a balancing payment and an advance instalment towards the next year, while also repaying the capital loan. A partner who does not plan for this often needs to borrow again. Firms that operate tax retentions from drawings largely avoid the problem, and where they do not, there are ways of funding a partner's first tax bills.

Partner capital is not a savings account. If the firm is wound up, capital is usually lost before creditors are paid, while the personal loan remains repayable. Before borrowing, read the firm's accounts as a lender would: check its lock-up, borrowing, PII claims history and how many partners have left recently. Be clear on how long it will take to get capital back if you leave, since some agreements return it over several years.

Tax relief on the interest can be available where a partner borrows to put capital into a trading partnership, within the annual cap on income tax reliefs; ask your accountant whether your loan qualifies. Borrowing of £25,000 or less by sole traders and small partnerships can be regulated consumer credit, which brings additional protections. Where the firm asks you to give a personal guarantee for its own borrowing as well, that is a separate exposure on top of your capital loan.