Jennifer Adams looks at some tax tips and traps that may arise when being a member of a business partnership.
For income tax purposes a partnership has no legal existence distinct from the partners themselves (this is not the case in Scotland where a partnership is a legal person) and as such each partner is taxed on their share of profit as an individual. The effect of this provision ensures that an individual is treated as commencing their business when they start to trade, even if that was before they became a member of the partnership. Similarly cessation of their business need not necessarily be when the partnership is dissolved. One 'trap' is that as partners each is jointly liable for any debts owed by the partnership, each being equally responsible for settling the whole debt.
The principles of computation of a partnership's tax adjusted profit are the same as for any sole trader (although partner's salaries and interest on capital are not tax deductible since these items are deemed an allocation of profit). The resulting amount is then allocated between the partners according to the profit sharing arrangements as per the partnership agreement (if there is one) or equally if one does not exist. The partners then pay tax and Class 4 NIC on his or her share of the partnership profits.
One 'trap' is that on calculating the profit allocation one partner may appear to receive a negative share (termed ‘notional loss’). This situation could arise where, for example, partnership salaries are allocated before profit. To satisfy this anomaly this 'loss' amount is reallocated to the other partners in the ratio of their entitlement to profits. However, as it is not a ‘real’ loss no loss relief claims can be made against any other income that the partners may have.
Profit sharing ratios can be changed each year (unless set ratios are given in the partnership agreement). This point may impact where a partner joins or leaves a partnership and the profit sharing ratio of partnership assets (e.g. premises or goodwill) changes. Each partner is treated as owning fractional interests in a partnership asset and any change in that interest is treated as a disposal for CGT purposes. Where the partnership disposes of an asset to someone outside of the partnership (whether by sale or by gift) then all partners are treated as disposing of their share of interest in the asset.
If a partner makes a gift of the partnership interest, or dies so that the partnership interest forms part of their estate, a transfer of value is made and as such may be liable to an IHT charge. There is no transparency provision within the IHT legislation therefore, on the death of a partner, the asset, which must be valued and included within their estate, is the interest in the partnership itself, not the underlying asset of the business. Where there is no formal agreement, the Partnership Act 1890 provides that the partnership ceases. The partnership itself may not die but instead changes into a different partnership. The partnership will be required to sell the assets to pay off any creditors and then distribute the funds to any remaining partners and the deceased partner's wife, as per his will.
Practical tip
Where a partnership agreement exists provision for such 'traps' as outlined above can be made as the agreement will generally take precedence over any clause in a will or the default position should the partner die intestate. Such an agreement usually contains provisions allowing for the partnership continuation, confirmation of what happens to the partnership interests and whether the partners' heir(s) can sell the interest to another.
