The tax system for partnerships

Registering with HM Revenue & Customs

What profits do HM Revenue & Customs tax
How is the tax collected?
What about the complications?
What about national insurance?

If you form a partnership to carry on a business, you must register it separately with HM Revenue & Customs even if the partners have previously been self employed. If the partners are new to business, they must also register individually. Partnerships are registered with a special HM Revenue & Customs partnership team, based at Longbenton near Newcastle.

As a partner in a business you become liable for class 2 national insurance contributions and must notify HM Revenue & Customs by 31 January after the end of the tax year in which you became a partner. You may register online, by telephone or by using the form (CWF1) incorporated in leaflet SE1 (Are you thinking of working for yourself?).

Partners in firms are taxed on their share of the profits of the firm for the tax year, and the basis of tax is similar to that for the self employed. Each partner is effectively taxed as if he were a self employed business, with profits equal to his share of the profits of the firm. So, instead of tax (and national insurance) being deducted from your earnings at source, you must be prepared to receive a bill at some time in the future. This can be an unwelcome surprise if you haven't put enough money aside.

We aim to give you as much warning as possible of the likely timing and amount of tax payments, but it is not easy to do this during the first year of your new business, or if you do not keep your records up-to-date.

The hardest thing to understand in the world is income tax - Albert Einstein

What profits do HM Revenue & Customs tax?

The starting point for the calculation of taxable profits of the partnership is the profit and loss account, in the same way as for a sole trader. In calculating taxable profits the firm is entitled to claim deductions from your business income in respect of any expenses incurred for the purposes of trade (with a few minor exceptions).Partners will need to ensure that all of the expenses they wish to claim for are included in the profit and loss account as there is no option to deduct these from your share of the profits after allocation between the partners. So if any partners also run an office from home, or they bear mobile telephone or other costs personally, these need to be accounted for through the profits of the firm in order for them to benefit from tax relief.

When you buy equipment or motor vehicles, you will be entitled to deduct a proportion of the cost each year you own them and use them in your business. Claims for such capital expenditure are known as capital allowances.

If partners take stock for their own use, the disposal should be shown in the accounts at market value, and not at original cost. It may be possible to avoid this by arguing that such items never actually formed part of your stock and showing the original purchase as private expenditure (drawings).

Tax is payable on the whole of the profits of a trade, which is divided up between the partners according to the profit sharing agreement. Payments for partners’ own 'wages' (drawings) are not deductible. However, if a partner’s spouse works in the business, the wages are an allowable deduction, provided they are actually paid and are a reasonable reward for what is done.

How does HM Revenue & Customs allocate profit to tax years?

The aim of the system is that over the lifetime of your business the profits will be taxed in full, once, and once only. But to make the system fair, there are certain complications you will have to cope with.

The general rule is that the tax for a particular tax year is based on the profits of the twelve months to your accounting date in that tax year. For example, the tax for 2010/11 could be based on accounts for a year ending on various dates ranging from 6 April 2010 to 5 April 2011. This demonstrates that you get more time for the tax to be worked out if your accounts end early in the tax year, which is why 30 April is such a popular year-end for self-employed people, including partners.

How is the tax collected?

Tax returns

Tax returns covering income for the year ending 5 April 2010 have to be submitted to HM Revenue & Customs by 31 October 2010 for paper returns or 31 January 2011 for online returns. The return will include a self assessment of your liability to income tax and capital gains tax.

There is a partnership return which shows the profit and loss account of the partnership and any adjustments made for tax, including the capital allowances. This shows the profit shares allocated to each partner on the Partnership Statement. Each partner then also completes a return on his own behalf showing the share of partnership profits corresponding to the partnership return.

There is no such thing as a good tax - Winston Churchill

If you don't want to work out your own liability, you must send the tax return back by 31 October 2010 or file online by 30 December 2010.

There are automatic penalties for late filing of tax returns.

Partnership returns may also be filed online, but HM Revenue & Customs does not provide free software to do so. If you wish to file a partnership return online you will need to purchase suitable software – there are details of approved providers on the HMRC website.

Payment of tax

Payments on account of income tax and Class 4 NIC will be due on 31 January and 31 July. These interim payments will be based on one half of the total liability (less any tax deducted at source). You will have the right to reduce payments on account if you believe the income tax for the current year is less than the previous year.

The balance of income tax for 2009/10 is due on 31 January 2011 (along with the first interim payment for 2010/11 and any capital gains tax for 2009/10).

Interest and surcharges will be levied for late payment.

In the first year of the business, or your first year as a partner of an existing business, you will not have made payments on account towards your tax liability, as these are based on the previous year’s tax liability. This means that the first tax bill can be a real shock, as a full year’s tax, plus a payment on account towards the following year can all become due at once. After quite a long period without paying tax, paying one and a half year’s worth at one go can be quite an unpleasant surprise.

What about the complications?

Opening years

In the first tax year of your business, (which might be the year that the partnership starts up, or may also be the year you become a partner in an existing partnership) the tax payable is based on the profit arising between the starting date (or the date you joined the firm) and the following 5 April. Say a partnership starts up on 1 June 2010 and the first accounts run to 30 June 2011 with a profit of £13,000, shared equally between the two partners then tax will be worked out (to the nearest month) on the profits of the following periods:

2010/11 1 June 2010 to 5 April 2011 - 10/13 x £13,000 i.e. £10,000
2011/12 1 July 2010 to 30 June 2011 - 12/13 x £13,000 i.e. £12,000

Each partner is then allocated his share of the amounts taxable on the firm for the two years. You can see that the profit from 1 July 2010 to 5 April 2011 (9 months) has been taxed twice on each partner. The 'overlap' profit of £9,000 (£4,500 each) will be available for deduction when the partnership comes to an end, or one of the partners leaves the firm. Overlap profits also change when the firm changes accounting date. In a partnership, overlap profits are personal to each partner, rather than applying to the firm as a whole, as each partner will generate overlap profits on joining the firm, depending on his share of the profits at the time he joins.

For example, C joins the firm of A & B (above) on 1 January 2012, and takes a share of the profits for the period to 30 June 2012 of £10,000, his tax will be based on the following calculation :

2011/12 1 January 2011 to 5 April 2011 3/6 x £10,000 i.e. £5,000
2012/13 1 January 2011 to 30 June 2011 £10,000

Because his second tax year does not run for a full 12 months, he would be taxed on the first six months of his share of the profits for the accounts to 30 June 2013 in 2012/13, bringing that year to 12 months, and creating overlap profits of the three months from 1 January 2012 to 5 April 2012, and the six months from 1 July 2012 to 31 December 2012, which will be taxed again in 2013/14.

What about national insurance?

The self-employed including partners are subject to a two-tier system of national insurance contributions. Class 2 contributions are at a flat rate of £2.40 per week, payable against a quarterly bill or by direct debit from your bank account, if earnings exceed £5,075 per annum.

Each partner’s profits between £5,715 and £43,875 are subject to Class 4 contributions at a rate of 8%. Profits in excess of £43,875 are liable to Class 4 contributions at the rate of 1% without any upper limit. Class 4 contributions are collected by HM Revenue & Customs and are payable at the same time as the instalments of income tax.

If you do not register your liability to class 2 National Insurance your liability will be up to a maximum of 100% of the lost contributions for a deliberate failure; concealed failure 70% and all other cases the penalty is 30%. There will be no penalty if there is a reasonable excuse for the failure to notify.

Save for your tax

It is essential that you make proper provision to ensure the availability of funds to pay income tax and Class 4 national insurance. Interest on unpaid tax is chargeable by HM Revenue & Customs, and is not deductible from business profits.

Please call us if you would like further help or advice on this matter.