Armstrong Watson has a great deal of experience in helping and advising prospective equity partners on the implications of such an appointment and whether or not to accept the offer. We have recently been instructed to advise on a number of offers made to solicitors. Our advice covers the technical taxation implications and also the more commercial factors such as the deal being offered, the prospects for the firm and the individual and how to finance such an offer.
This article concentrates on the taxation and capital requirements issues, but there are a whole host of other factors that should be taken into account and we would be happy to advise any firms or individuals as they plan for the future.
On becoming an equity partner, you will be treated by HM Revenue and Customs as becoming self employed. Your employment will cease and you will be issued with a P45 even if you are becoming an equity partner in the same firm. You will be required to complete a self assessment tax return and will stop paying tax under Pay As You Earn, making only two payments of tax per year in January and July.
Your tax will now be calculated with reference to your share of the partnership’s tax adjusted profits. This figure will not necessarily be the same as the profit share allocated to you in the accounts as it will reflect adjustments for expenditure which has been deducted in the accounts but is not allowable for tax purposes, and also specific tax allowances such as capital allowances.
Once established, your tax will be based on your tax adjusted profit share for the year ending in the year of assessment. So, for example, your profit share in the accounts for the year ended 30 April 2019 will be declared on the 2019/20 Self Assessment Tax Return. There are however special rules for commencement and cessation.
In the tax year in which you become an equity partner, you will be assessed on the profits arising from the date of your commencement to the following 5 April. Thus, if partnership accounts are prepared to 30 April 2019 and you were appointed on 1 May 2018, in 2018/19 you will be assessed on the profits arising in the period 1 May 2018 to 5 April 2019. Tax will be payable on these profits in January 2021.
You should note that there can be a considerable delay between the date on which you are appointed and the date on which your tax payment is due. It is therefore important to make provision for this payment. Some firms will hold back monies in a tax retention account and deal with tax payments on behalf of the partners, but there is no obligation for all firms to do this and the situation should be clarified from the outset. If no tax provision is being made on your behalf you should ensure that you make adequate provision for your tax payment. Your accountant should be able to provide you with an estimate of your projected tax liability so that you can ensure that your provision is sufficient.
Special rules also apply to the second year of assessment, 2019/20 in the above example, which is based on the profits for the year ended 30 April 2019. The tax in this respect will be payable in two payments on account in January and July 2019, based on your 2018/19 liability, with a balancing payment if required in January 2020.
There is usually an element of double counting of profits in the opening years of an equity partnership. In the example above, profits for the period 1 May 2018 to 5 April 2019 have been assessed both in 2018/19 and 2019/20. A calculation is therefore undertaken to quantify the profits assessed twice and this is called ‘overlap profit’. This is carried forward until your retirement from the partnership, the partnership ceases or the year end changes when it is deducted from the profits assessable in the tax year of change.
Depending on the accounts year end date, it is not unusual for tax returns for the first two or three years to show estimated figures of profit share, as they are based on accounts which may not be finalised until after the final date for submission. Whilst every effort should be made to ensure that the tax payments are as accurate as possible, it is 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 tax overpaid. Whilst not completely satisfactory, this is an unavoidable consequence of the way in which the opening year rules work and should be borne in mind.
A separate consideration when being offered an equity partnership is how much capital you will be required to contribute. You may be given several years to build your capital within the partnership out of your profit share but it is common for a substantial capital contribution to be required. So, how is this to be funded? If a loan is required, the interest on that loan is tax relievable and your taxable profits will be reduced pound for pound by the amount of interest paid on your loan. If further capital contributions are required as your profit share increases, the interest on any loan required to fund this will also be relievable.
A further consideration should be the Capital Gains Tax implications of buying into a partnership. On becoming an equity partner you may acquire a proportion of the goodwill of the partnership. Hopefully during your time as a partner the value of the goodwill may increase in value and if you receive payment for this when you leave the partnership, it could give rise to a Capital Gains Tax liability. Capital Gains Tax on the disposal of goodwill can also arise in some circumstances when the profit sharing ratio is adjusted. This is not true in all cases and depends on how goodwill is treated within the partnership. The way in which goodwill is dealt with and the Capital Gains Tax implications of this should therefore be clarified before the appointment is accepted.
Other issues that you should take into account when determining whether to accept an equity partnership offer include:
In conclusion, on becoming an equity partner, many things will change – possibly the most unusual change will be the way that you are taxed. You will be expected to pay your tax bills in January and July and it may take some time before your tax affairs are on an even keel. If you are prepared for these changes, the transition from salary to profit share should be a smooth one.