Jennifer Adams takes us through some recent developments on partnership tax.
Partnerships are the only business entities that can be formed by oral agreement, being created automatically when two or more persons engage in a business ‘with a view’ (to making)’a profit’ (Partnership Act 1890, s 1). There are no formalities on creation of a conventional partnership and apart from notifying HMRC, there is no registration; as such, it is a very flexible mode of business. However, trading through a partnership is not for everyone. This article looks at the different types of partnerships that currently exist, discusses the merits and otherwise of such entities, and considers the future rules to be included in the Finance Act 2014.
Partnership law and liability
Until this year, partnerships seem to have rather ‘dropped off the radar’ with each successive government since the law was consolidated in the late 19th century. Unlike current acts, the Partnerships Act 1890 contains only 47 clauses and apart from the introduction of a new type of partnership via the Limited Liability Partnerships Act 1907, the law has not been updated. At the time of enactment, partnerships were small concerns such that the maximum number of partners permitted was 20. That restriction has been removed and partnerships now vary in size, from two partners to many hundreds.
Different types of partnership
- A ‘conventional’ partnership is not a separate legal entity from its owners. All partners share in the firm’s profits, each being responsible for the firm’s debts, having joint, or joint and several liability. Any one partner could be called upon to satisfy an entire debt with the proviso of the right of contribution from the other partners. In comparison, the tax liability of each partner is not ’joint and several’. Property cannot be held in the partnership’s name, each partner being deemed to own a fractional share.
- Limited partnerships are a special kind of partnership. All the normal partnership rules apply, the main difference being that only active partners (termed ‘general’ partners) are fully liable to the debts of the business, whereas those who merely invest in the business but take no active management role (‘limited’ partners) are liable only to the extent of their capital investment, which may be a sum of money, or property valued at a stated amount. The partnership must be registered with Companies House, but there is no requirement for filing as for a company unless the Partnership Accounts (Regulations) 2008 apply (should the ‘general’ partner be a company). Again, tax is levied as a ‘conventional’ partnership not being a separate legal entity; however, it can hold land and property in its own name. Separate calculations are necessary should this partnership purchase a capital asset, each partner owning a fractional share and taxed on their proportional share of the gain (or loss) made. This type of partnership has become increasingly popular in recent years, in particular for venture capital funds, often being used to undertake property projects too large for a sole trader or conventional partnership.
- A limited liability partnership (LLP) is distinct from ‘limited’ partnership; there is a ‘general’ partner’ but there must be at least two ‘limited’ partners. An LLP is required to file similar information as a company to Companies House, including accounts.
Profit allocation
Individual partners pay tax and NIC as self-employed, each being required to pay calculated on their designated share of total profit. Should a company be a partner, it pays corporation tax on its share. The profit sharing ratio need not be the same every year, which is a valuable facility as it enables further flexibility. For example, should a partner receive additional income in any one year that takes him into higher rates, profits can be allocated to other partners at lower rates thus producing a tax saving for the partnership as a whole. Currently, HMRC cannot challenge the apportionment of profits within a partnership as they can with a company salary, but this ‘reallocation’ facility is affected from 6 April 2014 by anti-avoidance rules for ‘mixed partnerships’, which include a company.
HMRC have been known to contend that a profit reallocation may produce an element of ‘bounty’ under the ‘settlement’ legislation. A partnership agreement providing for the sharing of losses as well as profits is therefore advisable.
The importance of a partnership agreement
Profit shares are as detailed in the partnership agreement, should there be one. In theory they can be amended as many times as is wanted with no reference to the proportion of capital invested, the only proviso being that the amendment cannot be retrospective. The Partnership Act 1890 automatically applies to all unlimited partnerships unless the partners agree terms which override those in the act (e.g. the act always assumes profits are split equally).
A written partnership agreement is not legally required, but agreements not made in writing can lead to misunderstandings. Problems can arise when one partner disputes the allocation of profits and it is then that the importance of a formal partnership agreement is realised. Partnership agreements should also confirm such matters as the situation should one partner resign and confirmation is required as to the value of goodwill, whether using a particular formula or a third party value.
Partnership vs. company – Points to note
- Partners can withdraw monies as and when required, with no tax penalties for overdrawn loan accounts. There is no requirement to operate PAYE or to pass board resolutions.
- Should a new company make a trading loss (and there is no other income) there is no immediate tax relief as the loss can only be carried forward and offset against future profits from the same trade. Partnerships are akin to sole traders where losses can generally be offset against current and prior year’s profits or employment income.
- After a year a partnership can sell the goodwill of the business to a limited company, and the individual partners can potentially claim entrepreneurs’ relief, paying tax at only 10% with the company claiming relief on the goodwill amortisation against corporation tax.
- Withdrawing profits from a company in the form of dividends is more tax efficient because no Class 4 National Insurance contributions are levied. Only by such methods as dividend waivers can differing amounts be paid to each shareholder.
Anti-avoidance rules
Legislation is to be introduced in the Finance Bill 2014 with reference to the following:
- Employment relationships - HMRC is concerned that individual partners are benefiting from being treated as self-employed when in effect they should be treated as employees. The new regulations negate the automatic presumption of self-employment specifically for LLP partners. A new category of ‘salaried member’ has been created for when either the individual partner (‘member’) would be regarded as employed taking the usual status factors into account (see BTI February 2014 – ‘Employment Status – Expensive if you get it wrong!’), or bears no economic risk should a loss be made or the LLP be wound up. This ‘salaried member’ will be subject to PAYE income tax and the LLP will be liable to NIC as the employer.
- Profit and loss allocation schemes - HMRC are not appreciative of the use of partnership profit sharing arrangements that minimise the overall tax levied, with particular reference to arrangements that involve ‘mixed partnerships’ (i.e. a combination of individual and corporate partners taxed at different rates). As from 5 December 2013, should any tax advantages arise as a result of the differing tax allocation of the members involved, then the consideration received can potentially be treated as income of the transferor ‘member’. For further details, see the January 2014 article ‘Mixed partnerships beware – new anti-avoidance rules’.
Practical Tip:
Review your partnership agreement. In addition, consider the impact of the new anti-avoidance rules to be introduced in Finance Act 2014.
