Which Business Entity? Partnerships/LLPs

Lee Sharpe continues his series on the taxation of different business entities, this month looking at partnerships in their various guises.

This article, the third in the series, looks at the taxation of partnerships and their partners. The taxation of partnerships is relatively straightforward in terms of the basic principles, but there can be some quite complex issues in implementation. 

In this article, where I refer to a ‘partnership’, it will be in the context of a ‘general’ partnership, broadly governed by the Partnership Act 1890. There are other kinds of partnership, such as:

This is by far the most common type of partnership, and essentially arises when persons carry on a business together, with a view to making a profit. 

The legislation governing general partnerships allows people to join or to leave the partnership quite freely, and is perhaps the only kind of partnership that can come about ‘by accident’, on the basis that the other two categories need to be formally registered at Companies House. A general partnership may have a written agreement between its partners, but this is not a legal requirement (although it is highly recommended).

Basically, general partnerships are transparent to their underlying partners who (like the self-employed) have unlimited liability if there is a claim against the partnership. Worse, each partner is potentially liable for all of the partnership’s debts; any partner can be financially liable for the mistakes of another partner or all other partners, and even of a partner who has since left the partnership. 

Simply, each partner is deemed to be in business on his or her own account, albeit with a common set of financial results. The partnership tax return will allocate a slice of the tax-adjusted profit or loss to each partner, who will then account for it on his or her own tax return. Each partner will independently go through the commencement and cessation rules according to when they join and leave the partnership, which is deemed to continue. This ensures that each partner is, ultimately, taxed only once on all of the profits he or she generates.

Profit sharing – Partners may change their profit-sharing agreement at any time. This affords a measure of planning opportunity, particularly within a family partnership, so that all fully utilise their allowances, etc. According to HMRC, a partnership cannot change its profit-sharing agreement retrospectively – it must be fixed in advance. HMRC’s position is set out in its Business Income manual at BIM82055 (which is arguably more helpful than the limited guidance in HMRC’s Partnership manual). BIM82055 confirms that:

‘The sharing ratio need not be in proportion to contributions of effort or capital. It is not necessary for the partners to share profits and losses in the same proportions, nor income from other sources in the same proportions as trading or professional income.’

Having said that, readers should also have regard to HMRC’s Trusts manual (at TSEM4215), which indicates that HMRC might attack a disproportionate transfer of profits to another family member. Note in turn, however, that a change in profit share is not necessarily a gift only of income, such as may be caught by the ‘settlements anti-avoidance legislation’ (ITTOIA 2005, s 624 etc.) for transfers between spouses/civil partners. If anything, the examples at TSEM4215 indicate how difficult it may be for HMRC to challenge such changes. 

Loss sharing – While partners generally share their profits or losses as agreed, a partner may not make a loss for tax purposes while others make a profit, and vice versa (this could happen where one partner takes a prior call on profits of a fixed sum, which exceeds the available profits, effectively leaving the other partners to share in a notional loss). In such cases, the offending adjustment is restricted until all partners are in a similar position (either all making profits/nil or all making losses/nil). There are special restrictions for ‘sleeping’ partners, who are not substantively/actively involved in the business. 

Capital sharing/capital gains tax – Partners’ underlying capital sharing ratios may differ from their profit sharing agreement, and may change at different times. Where a partnership asset is disposed of, or where underlying interests in capital assets change between partners (including, but not limited to, when partners join or leave) then a capital gains tax (CGT) event occurs. This can become complex, and a working knowledge of HMRC’s Statement of Practice D12 is necessary (but beyond the scope of this article). See HMRC’s Capital Gains manual at CG27170 for further information. Note in particular that partners who are not otherwise ‘connected’ for CGT purposes will not be connected just because they are partners, for commercially-based transactions (SP D12 para 7; TCGA 1992, s 286(4)).

HMRC deals with a ‘nominated partner’ for resolving enquiries and disputes at partnership level. This can be particularly problematic where there is a dispute between one partner and his (generally former) colleagues as to his share of profits or losses, or where one partner disagrees with the nominated partner’s responses to HMRC in a tax enquiry. 

Unlike with direct taxation, a general partnership is a separate entity for VAT purposes, with its own VAT registration threshold. Supplies by individual members on their own account are independent of those provided by the partnership. 

One of the more complex issues for partnerships arises where the partners have an interest in land. Specialist advice is strongly recommended to ensure that stamp duty land tax (SDLT) is correctly administered – common pitfalls are when a ‘land-owning’ partnership’s constitution changes or land is introduced; also where there is a change in income sharing ratio (but as defined for SDLT purposes) (N.B. land and buildings transaction tax applies in Scotland instead).

1. Whist a general partnership is essentially transparent for direct tax purposes, HMRC has been good enough(!) to ensure that there are separate penalties for failing to file a partnership tax return, distinct from each partner’s own return. 

2. Partners may have incurred expenses personally on behalf of the partnership, which may not have been included in the partnership’s books or accounts. This may include capital allowances on plant and machinery (e.g. cars) used partly or wholly for partnership business. If partners want tax relief thereon, those expenses must be included in the partnership’s own tax return. Provision is then made at the profit-sharing level to ensure that each partner gets the direct benefit of his or her own additional costs and reliefs.

They require at least one general partner, with unlimited liability and at least one limited (liability) partner. Limited partners are not allowed to get involved with the day-to-day running of the partnership and, amongst other restrictions, the most flexible tax reliefs for their share of losses are basically restricted to the amount of capital they have invested. See HMRC’s Partnership manual at PM50100 et seq.

These have proved much more successful and are particularly popular amongst professional practices. Members’ liabilities are, again, generally restricted to the capital they have contributed. Whilst strictly corporate bodies, HMRC nevertheless treats them as general partnerships in almost all respects, save when insolvent, or where not carrying on a business activity with a view to profit (see PM50510 et seq.). Similar loss relief restrictions apply here as to limited partners.

Simply put, partnership tax affairs are quite straightforward...except where they are not! Advice from specialists who are familiar with partnership taxation is recommended.