Tax on Partnership Income

Partnerships themselves do not pay tax directly. Instead, the individual partners pay income tax on their share of the partnership profits. Each partner must report their share of the annual partnership profits or losses on their personal Self-assessment tax return and pay the relevant income tax accordingly. The partnership must file an annual Partnership Tax Return detailing the firm’s total taxable profit or loss for the year. Each partner’s share is based on the established profit-sharing ratio outlined in the partnership agreement. Partners are taxed on their profit share regardless of whether profits are withdrawn or retained in the business. Losses can be offset against other income. National insurance contributions may also apply depending on each partner’s circumstances.

Allowable deductions that partners can claim against their profit share include costs of goods sold, staff wages and contributions, premises costs, equipment, utilities, supplies, insurance, interest on capital borrowed for the business, repairs and maintenance, advertising and marketing, accounting fees, legal costs, bank charges and other costs integral to operating the partnership business.
However, partners cannot claim deductions for travel expenses, partner salaries, interest paid to partners on capital invested or drawings taken from partnership funds. Careful distinction of personal vs. business outlay is required in determining allowable deductions. Maintaining clear business records is crucial.

If the partnership makes an overall trading loss, individual partners can offset their share of this loss against other taxable income in the same tax year. For example, losses could be offset against a partner’s employment, dividends or rental income.
Any unused losses can be carried forward to subsequent years. However, losses cannot be carried back against income from earlier years. There are also restrictions on offsetting losses for partners who are limited liability partners.

The partnership must file an annual Partnership Tax Return by 31st January following the end of the tax year. This details each partner’s profit allocation. Partners must report their profit share on their personal Self Assessment tax returns and pay the tax due by 31st January for sole traders or 5th April for partners with other income. Partnerships must also make quarterly advance income tax payments by the 5th day of July, October, January and April based on estimated figures to avoid interest. New partnerships can apply for exemptions from quarterly instalments.

When deciding each partner’s profit share, HMRC looks at the partnership agreement and also expects to see that profits are shared in a just and reasonable manner, reflecting the partner’s contribution, role and responsibilities.
Suppose HMRC believes some partners have artificially inflated their expenses or derived disproportionately high salaries to minimise taxable profit allocations. In that case, they can challenge this and reallocate profits between partners in line with evidence of their duties, decision-making, capital investment, etc. Maintaining documentation showing how profit share decisions are made is important.

Partnerships face various financial penalties for errors and omissions in tax compliance, including:

• £100 automatic penalty for late filing of the Partnership Tax Return. Additional penalties will be charged after 3, 6 and 12 months.
• Interest on late payment of tax liabilities.
• Penalties on partners for errors in their returns depend on whether failures are careless, deliberate or fraudulent. This can range from 30% to 100% of tax underpaid.

There can also be non-financial consequences like greater scrutiny of compliance going forward or reputational damage with stakeholders like lenders.

The time limits within which HMRC can begin a tax enquiry are:

• 12 months after the normal filing date for undisclosed partnerships.
• 24 months after the normal filing date for published partnerships whose accounts contain a notice that the return is open to an enquiry under Section 12AC(1) of the Taxes Management Act.
• 4 years after the end of the accounting period for partnership returns, tax losses over £2 million are brought forward.

HMRC requires evidence of negligent conduct outside these limits before enquiring into earlier years. Keeping tax records for six years is advisable until matters are beyond enquiry.

Potential tax benefits for family members operating partnerships include:

• Profit allocations to children or spouses may face lower income tax rates depending on their total income and personal allowances.
• Spreading partnership income across family members can fully utilise personal allowances and minimise higher/additional tax rate exposure.
• Gross profits up to £50,000 can be allocated to non-active partners under certain conditions without incurring national insurance contributions.

However, profit allocations must reflect a genuine role in the partnership. They are artificially diverting income merely to gain tax advantages, risks being counteracted by HMRC if challenged.

For property rental businesses held in a partnership, the rental profits are allocated to each partner in their profit-sharing ratio and taxed accordingly. Expenses can be deducted in calculating rental profits, but the capital allowances regime does not apply to property partnerships in the same way as for other businesses. There are also limitations on offsetting property losses against other income for higher earners. Specific self-assessment reporting requirements exist for reporting property partnership income and expenses. Professional advice should be taken to ensure compliance.

When partners depart, they are treated as disposing of their share of all the partnership’s assets at market value for capital gains tax purposes. Any excess of market value over the partnership share in their capital account represents a chargeable gain for the departing partner. For a new partner acquiring an interest, the acquisition value is added to their capital account and represents their base cost for future chargeable gains. Ongoing profits or losses are shared between the partners based on the newly agreed profit-sharing ratios. Changes in the partnership constitution require adjustments in profit allocations and capital holdings. Early tax planning for departures or arrivals is advisable.