Key tax issues to consider when leaving an equity partnership

Last week we covered general liability and other issues to consider when leaving an equity partnership – in this article we concentrate on the tax consequences. When a partner leaves a partnership, for whatever reason, it will trigger the cessation rules for income tax purposes. There could also be capital gains tax issues as well as other financial considerations to be aware of.

Income tax
The departure of a partner is treated for tax purposes as the cessation of a profession and will invoke the ‘closing year provisions’ in respect of that partner. The assessable profits in the final tax year of the partner’s participation in the partnership will be that partner’s profit share in any accounts since the last period assessed.

So, for example, if a partnership makes up its accounts to 30 April annually and a partner ceases on 30 June 2009, his assessable profit share in 2008/09 will be based on the accounts to 30 April 2008, but his assessable profit share in 2009/10 will be based on the accounts to 30 April 2009 plus the period 1 May 2009 to 30 June 2009. Depending on the partnership’s year-end and the date of leaving, it is therefore possible to be assessed on more than 12 months’ profit share in one tax year.

To counter this, the overlap profits calculated in relation to the profit share assessed twice in the opening years of the partnership are deducted from the profit share assessable in the year of cessation. It is important, therefore, to keep a record of overlap profits previously suffered. If overlap profits exceed the assessable profit share, a ‘terminal loss’ is created which can be carried back and set against profit share assessable in the three years before the year of cessation.

The timing of the cessation can be important. A cessation on 31 March can mean that a partner finishes paying tax on his partnership profits an entire year earlier than a cessation from the same partnership on 30 April.

This consideration is particularly important following the 2009 budget, which announced an increase in the top rate of tax to 50% for taxable income in excess of £150,000 with effect from 6 April 2010, together with the phasing out of personal allowances for those earning more than £100,000. If a retirement is planned for a date shortly after 5 April 2010, there is a strong incentive to consider bringing forward the date to 31 March as a substantial tax saving may be achieved.

Each partner’s circumstances will be different when considering a date for leaving and there is no substitute for crunching the numbers to ensure the optimum cessation date is chosen.

If, following his departure, a partner’s income is substantially reduced (on retirement, for example) there may be potential to reduce his payments on account for the tax year after cessation. These payments are based on his previous year’s income tax liability, so if he has gone from a large share in the profits of a successful business in one tax year to a modest pension and some investment income in the next, a claim to reduce payments on account would almost certainly be advisable.

It is common for tax returns and payments to be due before the necessary partnership accounts have been finalised. It is not unusual for the final year’s self-assessment to be based on estimates. While every effort should be made to ensure that the tax payments are as accurate as possible, it is almost inevitable that figures will need to be revised and tax payments will need to be adjusted. This can mean a further tax payment and interest charges or a refund of overpaid tax. Though not completely satisfactory, this is an unavoidable consequence of the way in which the cessation rules work and should be borne in mind.

Having established which profits are assessable in which tax year, and having calculated the income tax payable, it is important to clarify who is responsible for paying the tax. Payments in respect of the liability in the final year of a partnership can become due a long time after the partner has left. The departing partner needs to know if the partnership will retain any tax reserve they may have made and meet the payments as they arise, or whether any tax reserve will be paid out on cessation, in which case the partner will need to set funds aside to meet the liability.

Capital gains tax
A partner’s liability to capital gains tax depends on how the partnership deals with its assets. It is perfectly possible to leave a partnership without incurring a capital gains tax liability if, for example, the partnership property is held as a partnership asset on trust for the partners of the firm, as opposed to outright by the partners individually, and the partnership does not recognise goodwill in the balance sheet of the business.

If, however, a value is placed on the goodwill and a payment is made to the partner on cessation for his share of that goodwill, this will trigger a capital gains tax liability. Unless he made a payment for goodwill on the commencement of equity participation, it is unlikely that there will be much base cost to set against proceeds received for goodwill and the gain arising could be substantial. Similarly, if he owns a percentage of the partnership’s premises and the other partners buy him out on cessation, this too will trigger a capital gains tax liability.

Generally speaking, capital gains tax is charged at 18% on any surplus of proceeds over the original cost. However, on a cessation the gain arising in respect of business assets might qualify for ‘entrepreneur’s relief’. This relief effectively reduces the tax charge on the first £1m of gains realised by an individual during their lifetime to 10%. This area can be complex and advice should therefore be sought as to the availability of this relief in any particular circumstances.

The capital gains tax arising out of a cessation can vary greatly from partnership to partnership. It is therefore important that a partner ensures he is fully aware of any potential liabilities which may arise.

Other tax issues
After ceasing, an equity partner may continue to receive income from the partnership. Examples of this include:

• Rent if he owns a share in the partnership premises and the other partners have not bought him out, he may continue to receive rent. This is taxable and should be declared on his self-assessment tax return.
• Interest on capital: if the partnership has retained some of the partner’s capital they may pay him interest on that capital. Again, this is a taxable receipt and should be declared on his self-assessment tax return.
• Consultancy fees: if a partner has semi-retired and is working on a consultancy basis, any fees received will be taxable. It is common for these fees to be treated as a ‘self employment’, but it is important to be aware that if the partner works only for the firm from which he has retired and the amounts they pay are fixed and regular, HM Revenue & Customs may argue that this is employment and require the partnership to deduct PAYE tax and national insurance from any payments made. The partner should also be aware that if consultancy fees are treated as self employment there is a requirement to register for VAT if invoices exceed the VAT registration limit (currently £68,000) in any 12-month period.

In conclusion, the financial implications of leaving a partnership can be complicated, but they will vary greatly from partner to partner, depending on his or her circumstances and the way in which the partnership is set up and operates. It is important to be clear as to the potential tax liabilities on cessation, who is responsible for the payment of those tax liabilities, and the departing partner’s obligation to declare future income derived from the partnership.

Income points

• A partner’s cessation on 31 March can mean that he finishes paying tax on his partnership profits a year earlier than a cessation from the same partnership on 30 April.
• The 2009 budget announced an increase in the top rate of tax to 50% for taxable income in excess of £150,000 with effect from 6 April 2010.
• It is not unusual for the final year’s self-assessment to be based on estimates, possibly necessitating increases in tax payments later.

Andy Poole is the solicitor services director at Hawsons Chartered Accountants and the UK chairman of LegalPlus, an alliance of solicitor specialist accountants.
Nicola Keene is a personal tax manager at Hawsons Chartered Accountants