If you are a partner in a business, you will be charged to income tax on your share of the profits, and you will also have to pay Class 2 and Class 4 National Insurance Contributions. But what if you have a “sleeping partner”? James Bailey highlights a tax case which could enable you to make a claim.
Class 2 NIC & Class 4 NIC
Class 2 NIC is a fixed weekly amount (currently £2.40p per week) and Class 4 NIC is based on a percentage of your share of the partnership profits. The current rate is 8% of the profits between £5,715 and £43,875 (a maximum of £3,053) and 1% on any profits above £43,875.
Class 4 NIC is charged on the profits “immediately derived from the carrying on or exercise of one or more trades, professions or vocations”.
“Sleeping partner”
A “sleeping partner” is a partner who does not take any part in the running of the partnership’s business. HMRC accept that such a partner is not liable to Class 4 NIC, because they do not fall within the definition above.
In the past, there has been a reluctance to classify a partner as a “sleeping partner”, particularly in the case of the standard husband and wife partnership. This was because there was a fear that HMRC would argue that the sleeping partner was not really entitled to their profit share, and that as a result the active partner had made a “settlement” on the sleeping partner by consenting to their having a share of profits they had not “earned”.
The fear was that HMRC would therefore seek to tax the active partner on the profits diverted to the sleeping partner – often with the result that those profits would be liable to income tax at 40% instead of the 20% they suffered in the hands of the sleeping partner.
“Arctic Systems” Case
In 2007 however, a tax case known as the “Arctic Systems” case went to the House of Lords, and the taxpayer won. In that case, a husband and wife had set up a limited company which received Mr Jones’ (the husband) earnings as a software engineer, and paid them out in dividends to Mr Jones and to his wife.
HMRC tried to argue that because Mr Jones had effectively given his wife the opportunity to enjoy the dividends from the company, he should pay tax (at 40%) on all of them. HMRC lost, and in their judgement, the Lords made it clear that the same argument would apply to a sleeping partner – each partner was taxable on their share of the profits, and HMRC could not tax the active partner on the profits of the sleeping partner.
This means that in a case where one of the partners does not actually get involved in running the business, that partner is not liable to Class 4 NIC. If they have in fact been paying their £3,000 plus of Class 4 NIC per year, they can make a claim for “error or mistake” relief to get it back.
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