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Taxation of Unincorporated Businesses by Malcolm James

Malcolm James, author of ‘Taxation of Unincorporated Businesses’ provides an introduction to partnerships, including limited partnership and limited liability partnerships.

Definitions

A partnership is defined as ‘the relationship which subsists between persons carrying on business in common with a view to profit’ (Partnership Act 1890 s.1). The term business includes all trades, professions and vocations. In England and Wales a partnership, in contrast to a company, is not a distinct legal person, therefore there is no distinction in law between a partnership and its member partners. In Scotland, but, a partnership is a distinct legal person. Even if a partnership has no separate legal existence, a partner is bound by the partnership agreement and all partners are jointly and severally liable for any acts or omissions of any partner. Partners also have unlimited liability for partnership debts, although they may sue other non‐paying partners for their share.

In order for a partnership to exist there must be an agreement between the partners, although this may be oral or implied through their conduct, and does not necessarily have to be in writing. The most important factor is the behaviour of the partners towards each other and the existence of an agreement is persuasive, but not conclusive, evidence of the existence of a partnership.

Within a partnership the usual status of a partner is that of a full equity partner who shares in profits and losses and who has unlimited liability for partnership debts. There are two special classes of partner.

Salaried Partner

A salaried partner receives a fixed amount of the partnership profits in the manner of a salary, therefore whether he is a genuine partner is a matter of fact and depends on, inter alia, his ability to enter into contracts which bind the other partners, the extent of his liability for partnership debts and his participation in the management of the partnership. If the facts demonstrate that the salaried partner is not in fact a partner the salary will be treated as an expense of the partnership, whereas, if the salaried partner is to be treated as a partner, his salary is an appropriation of profit.

Sleeping Partner

A sleeping partner provides capital for the partnership, but takes no active part in the management of the partnership. The sleeping partner’s profit share is treated as an appropriation of profit; however it is not treated as earned income.

Limited Partnerships

Under the Limited Partnerships Act 1907 certain partners of specially registered partnerships may limit their liability for partnership debts, to the amount which they originally contributed in the manner of the shareholder of a company. There must, but, be at least one partner (the ‘general partner’) who retains unlimited liability. A limited partnership must fulfil the following conditions:

• it must be registered with the Registrar of Companies (Limited Partnerships Act 1907 s.5) giving the firm’s name, nature and principal place of business, full name of each partner, the starting date and planned description;

• a statement that the firm is limited, with amounts contributed by the limited partners (Limited Partnerships Act 1907 s.8);

• at least one partner must have unlimited liability. This may be a corporate partner;

• limited partners must not take any part in the running of the business and must not have the power to enter into contracts binding the partnership.

The profit of the partnership is shared according to the normal rules (although no class 4 NIC is payable on the profit share of limited partners since it is treated as unearned income), but there are special rules relating to loss relief and other claims by limited partners.

Limited Liability Partnerships

The Limited Liability Partnerships Act 2000 now permits the formation of Limited Liability Partnerships (LLPs) which limit the liability of partnerships under the following conditions:

• the firm must be registered as an LLP and must comply with a disclosure regime;

• an LLP is treated as a corporate body, i.e. it is a distinct legal person with full legal capacity;

• the liability of members is limited to their actual and pledged contributions;

• financial statements must be disclosed in the same manner as for limited companies;

• similar rules to those applying to company directors relating to wrongful trading etc apply to members.

The main tax features of LLPs are:

• the LLP is treated as a partnership for the purposes of income tax and CGT (s.863);

• the loss relief rules applying to limited partnerships under the Limited Partnerships Act 1907 apply to non-active members of LLPs, except that relief is restricted to the amount subscribed plus any further amount pledged in the case of insolvency. There are anti‐avoidance rules to prevent the premature withdrawal of capital (ICTA 1988 s.118ZB, 118ZC). A non‐active member of an LLP is defined as an individual who devotes less than ten hours per week on average to the business of the partnership (ICTA 1988 s.118ZH(1) ;

• the LLP is treated as a partnership for the purpose of CGT (TCGA 1992 s.59A), except that the insolvency rules relating to companies apply in the case of an insolvent partnership;

• on insolvency any gain on which a partner has claimed roll‐over relief will become chargeable (TCGA 1992 s.156A);

• the LLP is treated as a partnership for the purposes of inheritance tax, therefore Business Property Relief will be available on the same basis as for partners in unlimited partnerships (IHTA 1984 s.267A);

• Stamp Duty Land Tax is not charged on the transfer of property from members of an old unlimited partnership (or their nominees or bare trustees) to an LLP, provided that the members of the unlimited partnership and the LLP are the same, and the share of the property owned by each partner does not change and the transfer is executed within one year of incorporation (FA 2003 s.65);

• class 4 NICs are payable on members’ profits shares from the LLP (SSCBA 1992 s.15(3A)).


October 2005

Malcolm James

Malcolm James is a Senior Lecturer in Accounting and Taxation at the University of Wales Institute, Cardiff.

The above article is adapted from ‘Taxation of Unincorporated Businesses’ published by Spiramus Press Ltd. To order Taxation of Unincorporated Businesses click here