Sarah Bradford highlights some planning tips for partnerships, and some traps to avoid.
The legal definition of a partnership is ‘the relationship that subsists between persons carrying on a business in common with a view to profit’.
However, unlike a company, for tax purposes a partnership is not regarded as a separate distinct entity and rather than taxing the partnership, the partners are taxed on their share of partnership profits. The profits (or losses) of the partnership are computed at partnership level and are allocated to the partners in accordance with the agreed profit-sharing ratio.
This article looks at some of the planning tips and pitfalls associated with partnerships.
Tip 1: Consider a flexible profit-sharing ratio
The profit-sharing ratio (PSR) depends on how profits and losses are shared between the partners. The PSR may be fixed; for example, the partners may agree to share profits and losses equally. This has the advantage of certainty, as each partner knows at the outset what their share of the profits will be. It also enables the partners to agree upfront an allocation with which they are happy and which is transparent.
However, from a tax planning perspective, this may not give the best result. An alternative is to have a more flexible PSR, which will allow profits to be allocated each year to minimise the overall tax liability. While this may not be regarded as acceptable where the partners have no personal connection, in a partnership where the partners are spouses or civil partners, a more flexible PSR can generate tax savings. Where this approach is adopted, the partners will have a PSR along the lines of ‘the partners agree to share profits and losses in such proportion as agreed between them’. Each year, the actual profit split will be determined according to their circumstances.
Example: Varying profit allocations
Joseph and Joanna are married and are business partners in the JJ Partnership. They agree to share profits and losses in such proportions as are agreed between them. In 2021/22, the partnership makes a profit of £50,000. Joseph has no other income. Joanna also has a part-time job in which she earns £40,000.
If they had shared profits equally, they would have each been taxed on partnership profits of £25,000. Joseph would pay tax at the basic rate of £2,486 on his share of the profits (20% (£25,000 - £12,570)). Joanna has already used her personal allowance and £27,430 of her basic-rate band, leaving £10,270 remaining. She would pay tax of £7,946 (£10,270 @ 20% + £14,730 @ 40%) on her share of partnership profits.
However, by sharing profits between Joseph and Joanna in the ratio 4:1, Joseph will be taxed on profits of £40,000 on which he pays tax of £5,486 (20% (£40,000 - £12,570)) and Joanna would be taxed on profits of £10,000 on which she pays tax of £2,000 (£10,000 @ 20%). This reduces the combined liability from £10,432 to £7,486, saving tax of £2,946 by moving profits of £14,730 from the higher rate to the basic rate.
If, in 2022/23, Joseph has other income of £45,000 and Joanna has no other income, and the partnership again makes profits of £50,000, the partners can agree to share profits in the ratio of 1:9, so that Joseph is allocated profits of £5,000 and Joanna is allocated profits of £45,000. This will ensure that the profits are all taxed at the basic rate.
By changing the PSR each year, it is possible to minimise the combined tax bill.
Tip 2: Claim tax relief for interest on a loan to buy a partnership share
Not all personal borrowings attract tax relief; so where relief is available, it makes sense to structure borrowings to take advantage of any available relief.
Subject to certain conditions, tax relief is available for interest on a loan that is used:
- to purchase a share in a partnership;
- to contribute money to a partnership by way of capital or a premium that is used wholly for the purpose of the trade or profession carried on by the partnership;
- to advance money to a partnership that is wholly used for the purpose of the trade or profession carried on by it; or
-
to repay a loan used for any of the above purposes.
Tax relief is contingent on the following conditions being met. The first condition is that throughout the period from the use of the loan until the interest is paid, the individual has been a member of the partnership, otherwise than as a limited partner in a limited partnership registered under the Limited Partnership Act 1907 or as a member of an investment limited liability partnership (LLP). The second condition is that in that period, the individual has not recovered any capital from the partnership other than that treated as repayment of the loan.
Thus, if an individual needs a loan, either to fund a house purchase or to buy into a partnership, it is more tax-efficient to take out a loan to buy a partnership share as this will be eligible for tax relief, whereas a mortgage is not.
Trap: Be aware that anti-avoidance provisions apply that deny tax relief where the sole or main purpose of the borrowings is to secure tax relief on the interest payments.
Tip 3: Claim relief for losses
A partnership may not always make profits. Where losses are made, these too are shared in accordance with the PSR. The partner can make use of the usual income tax loss reliefs. These include sideways loss relief, which allows a claim against general income or capital gains of the same or the previous year. This is subject to the usual cap on reliefs.
Where alternative claims are possible, the partner should seek to claim relief as early as possible and at the highest rate. Where sideways relief is not possible, the losses can be carried forward for offset against future partnership profits from the same trade.
Trap: Anti-avoidance provisions exist to counter arrangements that seek to exploit trading reliefs. In particular, restrictions apply to the use of early year losses by a non-active partner. Relief for sideways losses is restricted by the capital contributed by a non-active partner and is also subject to an annual limit of £25,000. A non-active partner is one working in the partnership for less than 10 hours per week. Restrictions on relief also apply to limited partners and members of LLPs.
Tip 4: Claim business asset disposal relief
An individual partner in a partnership is treated as owning the business carried on by the partnership. Consequently, they can access capital gains tax (CGT) business asset disposal relief (BADR) in the same way as a sole trader. BADR reduces the CGT charged on qualifying disposals to 10%, subject to a lifetime limit of £1m.
The relief is available on the disposal of assets used by the business on the disposal of all or part of the partnership in which the individual was a partner. It is also available on the disposal of assets used by the partnership which are disposed of within three years of the date on which the partnership ceases.
A partner can also benefit from relief on the disposal of assets owned by them personally and used in the partnership where the disposal is connected with a qualifying disposal of the partner’s interest in the partnership.
Traps: BADR is only available if the qualifying conditions are met throughout the relevant two-year period. Also, relief is only available for qualifying disposals of business assets, not a disposal of the partnership share.
Tip 5: Claim business property relief
Business property relief (BPR) provides relief from inheritance tax on the transfer of relevant business assets at either 50% or 100%. BPR at the 100% rate is available on the transfer of a share in a partnership. Relief is available at the 50% rate on land, buildings, plant or machinery used wholly or mainly for the purpose of the business carried on by the partnership.
Trap: The deceased partner must have owned their partnership share for two years before death or, as appropriate, the asset was used in the business for at least two years before being passed on.
Practical tip
Where a business is operated by individuals as a partnership, consider how to utilise the above tips to save tax.
