One of the perceived advantages of partnership and LLP membership has been that, save for salaried partners or members, partners and members are taxed on a self-employed basis.
One of the favourable aspects of paying tax on a self-employed basis is to potentially defer the payment of some tax to a later date than would be the case for an employee, particularly if the firm’s year-end does not align with the tax year.
The benefits of this deferment are now being brought to an end, with significant cashflow implications for firms.
1. What is changing?
The new legislation will change the way in which trading income is allocated across tax years.
A firm’s annual accounts will be drawn up to a specific accounting reference date each year, often 31 March, 30 April or 31 December. The profit for the year up to the accounting reference date is that of the tax year in which that date falls, which is known as the “basis period”.
The new legislation means that, from the start of the 2024/25 tax year on 6 April 2024, the basis periods of all partnerships and LLPs will be aligned to the tax year, irrespective of when the firm’s accounting reference date falls.
The current tax year (the year to 5 April 2024) is a transition year, for which the basis period will be 12 months from the end of the firm’s basis period for 2022/23, plus the additional time to 5 April 2024 following the end of such period.
These changes mean that, for example, a firm which had a 30 April 2022 year-end (which would mean its profits fell to be taxed in the 22/23 tax year) would have a basis period running from 30 April 2022 to 5 April 2024. The firm will be required to apportion profits from the two different accounting periods to produce a profits figure on the tax year basis, and initially file tax returns based on provisional figures, with amendments to be made in re-filed returns the following year.
This will mean that the firm’s partners will be taxed on nearly two years’ profits rather than one by way of a ‘catch-up’ to the new tax-year aligned basis period. The additional taxable profits can be spread over a period of five years, which will mitigate the cashflow consequences of the change.
2. Why are things changing?
The changes to the basis period will accelerate the speed with which income tax needs to be paid over to HMRC, therefore bringing the payment of tax closer to the point at which profits are earned.
The reforms are also aimed at simplifying the rules for allocating of trading income to particular tax years and removing the current requirements relating to double taxation of early years of trading profits (i.e. after a partner is admitted to the firm).
It appears that many firms will not align their accounting periods to the tax year, at least initially.
However, if a firm will change its accounting reference date to 31 March, so as to align the accounting period to the tax year, consider what needs to be done to effect this. This might include checking whether the partnership or LLP agreement contains a specific provision for approving the change to the accounting period (which will often be a vote of the partners or the management committee) and;
calling a meeting of the partners or management committee;
drafting the necessary resolution or meeting minutes; and
(if the firm is formed as an English LLP) file the relevant form with Companies House.
3. What do firms need to think about now?
Firms should by now have estimated the cash flow impact of the accelerated tax liability, which should take into account eventualities such as partners electing not to spread the profits in the transition year and future changes to tax rates.
The overriding consideration for the firm will be how to improve its cash position, in addition to the spreading across future tax years which is allowed under the reforms.
In many cases, there will be a range of legal and financial means by which potential cash flow issues might be avoided, although each has its own trade-offs. These include:
Increasing third-party loan facilities where possible.
Credit control measures such as reducing lock-up and debtor days or taking monies on account from clients in a wider range of instructions.
Changing partner incentive arrangements, for example, to reward paid bills rather than issued bills.
Deferring investments, for example, in IT equipment, premises or new technology such as AI software.
Requiring additional capital contributions from partners: If a firm is reluctant or unable to secure third-party loan finance (which itself may require a vote of the partners if it is over a certain specified threshold), it could be prudent to make a capital call from the partners. There will usually be a provision in the partnership or LLP agreement to require the partners to make additional capital contributions, although these are rarely exercised against a partner’s will, and most will not make express provision for the consequences of a failure to make the necessary contribution (such as a reduction in drawings to make up the shortfall).
Limiting partner drawings. In most cases this will be within the powers of the firm’s management committee or other governing body, but in other cases it will require a vote of the partnership. If the management committee decides to exercise any power it may have to reduce partner drawings. This may be open to legal challenge, for example if the reduction has a disproportionate impact on a partner or certain class of partner.
Management should consider carefully before exercising its powers under the partnership or LLP agreement. Such measures may be legally permissible under the firm’s constitutional documents if exercised properly and in good faith, but they still will require political buy-in from the wider partnership.
If the firm’s partnership or LLP agreement does not contain the necessary flexibility for the legal measures described above (such as increasing capital contributions or reducing drawings), the partnership or members’ agreement itself may need to be amended.
Most agreements will contain a mechanism to allow for this, typically by a vote of an enhanced majority (two-thirds, three-quarters or sometimes higher) of the partners. Should such a vote be necessary, firms should ensure that the rationale is properly considered and documented in order to minimise the risk of a successful challenge by a dissenting partner.
Many firms will consider adopting a combination of the approaches listed above, in addition to spreading the taxable profits over future years. This should help avoid more extreme measures such as deferring staff pay increases, reducing bonuses or selling non-essential assets.
Please get in touch if you require assistance with the current reforms and how to implement your chosen approach in accordance with your firm’s partnership or members’ agreement and other constitutional documents.
Need more information about the above people and legal expertise? Talk to one of our lawyers: +44 (0)20 7628 2000
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