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Legal Update - New rules for partnership profit sharing arrangements - Are they always fair?

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20 November 2017

In the 2016 Budget the Government announced proposals to review the way partnership profits and losses are allocated between partners for tax purposes. HMRC have long suspected practices of manipulating the allocations in order to gain a tax advantage (albeit a perceived one in reality). Following consultation, HMRC have produced draft legislation to be included in the Finance Bill 2018. This article illustrates the proposed changes and effect on taxable profits. We hope that losses are something our readers seldom encounter (although the principles are the same).

Whilst the Government does not wish to restrict the ability to allocate profits on a commercial basis, the proposed new rules remove any flexibility regarding how the tax-adjusted profits may be shared between partners. The current legislation simply states that a partner’s profit share follows ‘the firm’s profit-sharing arrangements. If the draft legislation is passed as it stands, the tax-adjusted profits will be shared in a strict ratio, based on the allocation of the commercial profits (i.e. the accounting profits), as stipulated in the partnership agreement.

EXAMPLE

The members’ agreement for ABC LLP states that Anne receives a fixed profit share of £30,000, and the remainder is shared 30% to Bob and 70% to Carol. For the current year, the commercial profit (as reported in the accounts) is £100,000, so the profit allocations are as follows:

 Anne £30,000
 Bob £21,000
 Carol £49,000
 Total £100,000

After making the normal tax adjustments (disallowing non-tax deductible expenditure, deducting capital allowances etc.), the tax-adjusted profit is £120,000. Anne receives a fixed share and none of the tax adjustments, so, based on the current rules, the profit allocations for tax purposes will be:

 Anne £30,000
 Bob £27,000 (30% of the balance)
 Carol £63,000 (70% of the balance)
 Total £120,000

In this common scenario, the net tax adjustments result in an additional profit (for tax purposes only) of £20,000, which is shared between Bob and Carol in the ratio that they share the balance of commercial profits.

The proposed new rules dictate that the tax-adjusted profit of £120,000 is shared in the effective ratio that the members share the profit commercially, which would result in the following:

 Anne £36,000 (30%)
 Bob £25,200 (21%)
 Carol £58,800 (49%)
 Total £120,000

Now Anne is taxed on £6,000 of the net tax adjustments, with a corresponding reduction of £1,800 for Bob and £4,200 for Carol. Overall, the same amount of profit is being taxed, but Anne will be acutely aware that, under these new rules, her tax liability is higher but the profit share she actually receives is not.

The above scenario is commonplace, with a large number of practices offering fixed share partners a profit allocation that is unrelated to the practice’s tax adjustments, so that they pay tax on what they receive (akin to a salary). Other practices may adjust for the disallowed costs that are directly attributable to the fixed share partners (akin to a salary plus benefit in kind).

For many legal practices with large amounts of entertaining expenses disallowed each year, taxable profit will be higher than commercial profit. In this case, the fixed share partners will be forced to share in all tax adjustments, with a corresponding reduction for the equity partners. The exception might be where there has been a large investment in equipment, where a large capital allowances claim might result in taxable profit being lower than commercial profits (and so the winners and losers will be reversed).

We expect that, more often than not, fixed share partners will lose out as a result of this change, and equity partners will gain. If these new rules are approved, all practices will need to reconsider their profit sharing arrangements. One school of thought is that it is right for fixed share partners to share in a proportion of the tax adjustments, in which case the outcome may be that no action is required.

As with many areas of tax, a change to one aspect can have consequences elsewhere. Where the practice operates as an LLP, fixed share members rely on their capital contribution to the LLP to determine a self-employed tax status. If their profit share is increased to compensate for their higher tax liabilities, then a larger contribution may be required.

LLP members taxed as employees through the payroll are unaffected by these proposals. HMRC confirmed via the ‘Salaried Member’ rules that these members do not share in the practice’s tax adjustments.

The new rules will take effect for accounting periods beginning after the Finance Bill receives Royal Assent, so it is likely that the first tax year in which partners will be taxed on this new basis will be 2018/19, although this will depend on the practice’s accounting date. Practices will be wise to start considering this now, particularly given the implications for profit share negotiations, and the calculation of tax reserves and drawings.


Andy Harris - Associate Partner
Andy Harris
Associate Partner Contact details