Lee Sharpe looks at some pitfalls of carrying on a business in partnership.
In this article, I’ll be looking at some of the consequences of taking on partnership status. There are different categories of partner and partnership, and the following serves only as a basic introduction.
You can become a partner by accident!
The Partnership Act 1890 defines a partnership as ‘the relation which subsists between persons carrying on a business in common with a view of profit’. There are exceptions to this, but there is no need for a formal arrangement, to give notice or to ask permission.
There may be various reasons why two or more persons acting together may not quite make a partnership, but it is nevertheless relatively easy to achieve – even if you didn’t intend to. Note that agreements setting out to deny the existence of a partnership may well fail, as it very much depends on the facts and intentions of the parties.
Joint and several liability
Each partner in a ‘normal’ or general partnership is personally liable for all the partnership’s debts, regardless of whether that person is entitled to (say) 50% of the partnership profits or gains, or just 5% of the partnership’s profits or gains. Simply put, if you are in a partnership that has large liabilities that the other partner(s) cannot afford, then your own assets (including non-partnership assets such as your own home) are potentially at risk.
It is possible to limit one’s personal liability and this is typically done using a limited liability partnership (LLP), but there are potential consequences to that, as well (see below).
Bringing assets into a partnership
One of the less obvious problems with creating or joining a partnership is that assets subject to capital gains tax (CGT), such as property or goodwill, may trigger a charge if brought in as partnership assets.
Example: Becoming a business partner
Archibald, a florist, agrees to go into partnership with Bill and Ben. All profits and business assets are shared equally. Archie owns his flower shop, so he has basically ‘sold’ 66% of his shop in exchange for a 33% stake in all the other partnership assets, potentially triggering a CGT charge.
Whether or not an asset belongs to the partnership, or is separately owned by one or more partners, can also be a contentious area.
Changing the sharing ratios…
Things can become complicated whenever partners agree to change their respective shares in the partnership, such as when joining, gaining seniority, or ultimately when retiring. Here again, the logic is that a person who agrees to end up with a smaller share must have disposed of some of their prior ownership.
This might seem counter-intuitive, given that one then has less of something but possibly nothing tangible to show for it; however, that is how CGT applies to changes in fractional ownership of partnership assets. The person who gets a (larger) partnership share has effectively made an acquisition, so there is generally no CGT to worry about for them at that stage.
…Capital gains tax
When it comes to CGT on partnership assets, HMRC follows Statement of Practice D12. This can be helpful, because this will often result in a broadly ‘no gain, no loss’ treatment, in that the proceeds are deemed to be equivalent to the corresponding cost. However, there are several complicating factors, such as:
- Where one or more assets has previously been the subject of a holdover election or similar, so that its CGT base cost has been depressed below cash cost in the accounts;
- An asset (typically property or goodwill) has been revalued in the accounts;
- The partners are ‘connected’ with each other (other than by way of being in partnership with one another);
- Where a partner receives consideration for the reduction in capital share, outside of the accounts.
CGT follows the capital ownership ratios between respective members, which can be separate (and differ in value) from the income profit sharing ratio(s).
…Stamp duty land tax (and equivalents)
Stamp duty land tax (SDLT) (and its devolved territory equivalents) can be another difficult area for partnerships. Very broadly, a partnership carrying on a trade or profession will not be troubled overmuch, but property investment partnerships in particular need to keep a close eye on:
- Property being added by partners to the partnership;
- Changes in sharing ratios, such as when a new partner is added.
Note, however, that when it comes to SDLT, it is changes in income-sharing ratios that drive the liability, not capital-sharing ratios as for CGT above.
How to limit that unlimited liability?
There are several different types of ‘limited’ partner or partnership, which generally work to limit an individual’s liability to (no more than) the capital they have invested in the business. By far the most common of these is the LLP.
For tax purposes, the LLP itself is almost always treated as if it were a general partnership. But each partner in, or ‘member’ of, an LLP is protected by that limited liability. There are more rules to an LLP (e.g. notably, it has to file returns with Companies House) to offer some safeguards and information to potential creditors of the LLP.
There are also a number of tax restrictions applied to LLP members, recognising that their own risk has been significantly reduced. For example:
(a) Loss relief restriction – A member’s (partner’s) share of trading losses can be set against other income, profits or gains only to the extent of the capital contributed from their initial membership onwards, as adjusted for any further contributions and withdrawals since (and previous such loss relief claims). There are several steps to the calculation, but essentially such LLP losses may enjoy the flexibility of being set against something other than LLP trading income, only to the extent that the member has capital at risk. Similar provisions apply to corporate members as for individuals. There is a separate £25,000 cap where the member is not actively involved in the trade.
(b) Interest relief restriction – A member of an LLP undertaking mainly investment business (by far the most common of which would be a property investment LLP) gets no tax relief for interest paid on any funds they borrow to invest in that LLP. Note that this does not apply to LLP members where the LLP is mainly carrying on a trade or profession in that chargeable period, nor to funds borrowed by the LLP itself.
Conclusion
A critical point to keep in mind is that the ‘joint and several liability’ rules for general partners do not ‘care’ whether you intended to be in a partnership or not. Nor do potential creditors.
This is why general partnerships between spouses, civil partners or other family members are relatively common, but less so between relative strangers. LLPs as an alternative are increasingly favoured by the professions such as law, tax and accountancy, as they offer each member much better protection from the joint and several liability risk of the standard general partnership. It is also practically impossible to become a member of an LLP by accident. The trade-off for reduced personal risk is that the reliefs for LLP members are not as generous as for general partners, as noted above.
While changing ratios between spouses and civil partners will generally be straightforward, note that CGT may be more problematic for partnerships involving other relatives because they may be ‘connected parties’ for CGT purposes, but not enjoy the special treatment for spouses and civil connected parties. They can then be caught out for CGT purposes when sharing ratios change, etc., in scenarios where otherwise unconnected partners would not.
Regular readers will be aware that HMRC will usually insist that co-owned landlord businesses are simply joint investments, rather than fully-fledged partnerships. The potential SDLT charge for property investment partnerships whose partners (or members in an LLP) have changed income/profit-sharing ratios is a giant-sized elephant trap lying in wait for those who try to argue that they are in a fully-fledged property partnership, without having taken expert advice and checked their previous mileage beforehand.
