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Business Clinic: tax issues of profit-sharing for partnerships

Whether you have a legal, tax, insurance, management or land problem, weekly farmersBusiness Clinic experts can help.

Here, Andrew Robinson, Partner and Head of Agriculture at Armstrong Watson, discusses tax and non-tax issues to consider when it comes to profit sharing.

See also: Business Clinic: What are the tax issues of selling shares?

Q. I am in partnership with my parents. In recent years, I received 50% of the profits and my parents 25% each. It has been suggested that there will be a tax saving this year if I get less and my parents get more. Can you advise if this is a good idea?

A. There’s a lot more to consider than tax bills when deciding how to split profits. I’ll look at the non-tax issues first, before getting to the practicalities of changing the allocation.

One of the most important sections of partnership accounts is often overlooked in family businesses – the statement of the partners’ capital accounts and current accounts.

This shows how assets are held within a partnership and what you will receive in return if you withdraw from the partnership. Don’t assume that because you receive 50% of the profits, you own 50% of the business.

A person’s capital ownership in a partnership will depend on the following:

  • The amount of capital initially invested or offered to you
  • The share of annual profits allocated to you
  • The number of designs removed from the business
  • Your right to profits on the revaluation or sale of fixed assets such as land

It is not uncommon for young partners to have a small equity stake in the business, as their share of profits each year and the drawdowns made are broadly the same.

Where one partner in a business is subject to income tax at 40% on his profit share and others have not used up all of their 20% tranches, profit reallocation can achieve savings.

Similarly, if some partners are over the statutory retirement age, they are not subject to class 4 national insurance, and there may be a saving in allocating more benefits to them.

However, under HMRC guidelines, a business cannot retrospectively change its profit-sharing arrangement.

Therefore, if you have signed a partnership agreement which states that you are entitled to 50% of the profits, HMRC may argue that you can only change this for future years.

Many modern partnership agreements include a mechanism for the partners to determine the allocation of profits after the end of the accounting period, allowing the profits to be shared more tax efficiently if the partners agree.

However, as mentioned above, a reduced profit share will result in a lower current account balance, which means a lower payout upon future retirement from the company.

Consider what happens if the partners cannot agree on how to share the benefits.

If there is no provision in the partnership agreement, or if you have no agreement, the default position under the Partnership Act 1890 is to split the profits equally.

One solution is for the partnership agreement to include a default profit-sharing agreement that only applies if the partners cannot agree.

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