Sarah Bradford explains how a flexible profit-sharing ratio works and when it might be advantageous for a partnership to adopt one.
----------------------
This is a sample article from our business tax saving newsletter - Try Business Tax Insider today.
---------------------
The Partnership Act 1890 defines a partnership as ‘the relationship that subsists between persons carrying on a business with a view to profit’.
However, unlike a company, a business partnership is transparent for tax purposes. The partnership is not taxed on the partnership profits; rather, the individual partners are taxed on their share of the partnership profits.
Sharing profits
If each partner is to be taxed on their share of the partnership profits, there must be a mechanism for sharing the profits between the partners. This is something that must be agreed by the partners; the legislation does not prescribe how profits and losses must be shared. Nor is there any requirement for profits and losses to be shared in proportion to the partners’ capital contributions.
The profit or loss is calculated at partnership level and then shared between the partners in the agreed ratio. The ability to choose how to share profits can be beneficial from a tax planning perspective.
However, the profits for an accounting period cannot be varied retrospectively after the end of the accounting period. This means that it is not possible to tax plan retrospectively by changing the profit-sharing ratio after the year end to secure a more favourable outcome. However, it is possible to overcome this restriction with a flexible profit-sharing ratio (see below).
Fixed profit-sharing ratio
The profit-sharing ratio (PSR) may be fixed. The partners may agree to share profits and losses equally or they may agree a different split. For example, in a three-partner partnership, the partners may agree to share profits in the ratio 6:3:1.
A fixed profit-sharing ratio has the advantage of certainty as each partner knows at the outset what their share of the profits will be. It also enables the partners to agree up front an allocation with which they are happy, and which is transparent.
A fixed profit-sharing ratio is likely to be preferred where the partners are not related or in a marriage or civil partnership.
Example 1: Fixed profit-sharing ratio
Andrew, Brian and Christopher are in partnership together. They have agreed to share profits in the ratio 5:3:2.
In the year to 31 March 2023, the partnership makes a profit of £150,000.
The profits are shared in accordance with the PSR as follows:
-
Andrew: £75,000 (5/10 x £150,000)
-
Brian: £45,000) (3/10 x £150,000)
-
Christopher: £30,000 (2/10 x £150,000)
Each partner is taxed on their share of the profits, which must be added to any other income that they receive in the tax year to calculate their total tax liability for the year.
Flexible profit-sharing ratio
A fixed profit-sharing ratio may not give the best result from a tax perspective, particularly when any other income that the partners may have is uncertain.
An alternative is to have a more flexible PSR, which will allow the profit split to be agreed each year to minimise the overall tax liability. While this may not be regarded as acceptable where the partners have no personal connection, in a partnership where the partners are spouses or civil partners, a more flexible PSR can generate tax savings.
Where this approach is adopted, the partners will have a PSR along the lines of ‘the partners agree to share profits and losses in such proportion as is agreed between them’. Each year, the actual profit split will be determined according to their circumstances.
Example 2: Your flexible friend!
David and Emma have been in partnership for many years.
To enable them to share profits in a tax-efficient manner and to minimise their combined tax bill, they have agreed to share profits and losses in such proportion as is agreed between them.
In 2022/23, David earns £40,000 from a part-time job. Emma has no other income. The partnership makes a profit of £50,000 for the year to 31 March 2023. Had they agreed to share profits equally, they would have each been taxed on partnership profits of £25,000.
David has already used his personal allowance of £12,570 and £27,430 of his basic rate band against his income from his employment of £40,000. This leaves £10,270 (£50,270 - £40,000) of his basic rate band remaining. If the profits had been shared equally, David would pay tax of £7,946 (i.e., £10,270 @ 20% + £14,730 @ 40%) on his share of the partnership profits.
Emma would pay tax at the basic rate of £2,486 on her share of the profits (20% (£25,000 - £12,570)).
With an equal profit-sharing ratio, their combined tax bill on the partnership profits would be £10,432.
However, if they adopt a flexible profit-sharing ratio, sharing profit in such proportion as is agreed between them, they can agree to split profits in the ratio 4:1, with Emma having four-fifths of the profits and David having one-fifth of the profits. In this scenario, David would be allocated profits of £10,000 and Emma would be allocated profits of £40,000.
David’s profits would fall within his remaining basic-rate band and would be taxed at 20%, generating a tax liability of £2,000 (i.e., £10,000 @ 20%).
The first £12,570 of Emma’s profits would be covered by her personal allowance. The remaining £27,430 would be taxed at the basic rate of 20%, giving rise to a tax liability of £5,486.
By adopting a flexible profit-sharing ratio, the couple’s combined tax liability is £7,846. This is £2,946 lower than if they had shared profits equally. By choosing the 4:1 split, they are able to utilise David’s remaining basic-rate band while ensuring any further profits are taxed on Emma and fall within her available basic-rate band.
A flexible profit-sharing ratio allows the split to be reviewed each year to reflect the circumstances.
In 2023/24, Emma has other income of £45,000 from letting out a holiday cottage that she has inherited. David has given up his job to focus on the partnership and has no other income. The partnership makes a profit of £50,000 for the year to 31 March 2024.
Had the PSR of the previous tax year been fixed, with profits being shared between Emma and David in the ratio 4:1, as previously, Emma would receive £40,000 of the profits and David would receive £10,000 of the profits.
As Emma now has other income of £45,000, which uses up her personal allowance of £12,570 and £32,430 of her basic-rate band, she only has £5,270 (i.e., £37,700 - £32,430) of her basic rate band remaining. For 2023/24, £34,730 of her partnership profits fall in her higher rate band. She will pay tax on her partnership profits of £14,946 (i.e., (£5,270 @ 20%) + (£34,730 @ 40%)).
David has no other income for 2023/24. His share of the partnership profits of £10,000 is sheltered by his personal allowance, and he pays no tax on those profits. However, the remaining £2,570 of his personal allowance is wasted, as is his basic-rate band.
Adopting the same PSR as in 2022/23 would mean that the couple’s combined tax bill is £14,496, i.e., £6,650 more than sharing the same profits in the same proportion in the previous year.
Had the PSR been fixed, the couple would not be able to amend it retrospectively after the end of the year to reflect their changed circumstances and reduce their combined tax bill. However, because they have a flexible PSR, they can take account of the actual position for 2023/24. They agree to share profits in the ratio 1:9, with Emma having one-tenth of the profits and David having nine-tenths of the profits. This means that for 2023/24, David is allocated £45,000 of the profits and Emma is allocated £5,000 of the profits.
The first £12,570 of David’s profits are sheltered by his personal allowance and the remaining £32,430 are taxed at 20%, giving rise to a tax liability of £6,486.
Emma has £5,270 of her basic-rate band remaining. Her share of the profits falls within her basic-rate band and she is taxed at 20% on those profits, giving her a tax liability of £1,000.
By having a flexible PSR and tailoring the profit split to their circumstances, they can reduce their combined tax bill to £7,486.
Losses
Losses are also allocated in accordance with the PSR. As with profits, the use of a flexible PSR allows the spouse to make best use of losses to maximise relief.
Practical tip
A flexible PSR can allow profits and losses to be shared in a way that secures the best overall tax result.
