In a partnership, the activities are considered to be conducted by the individual partners rather than the partnership itself, as a partnership is not a separate legal entity. Consequently, the partnership does not pay tax or National Insurance contributions (NIC). Instead, each partner pays tax separately on their allocated share of profits or losses, similar to a sole trader. If one partner is a company, it is taxed on its share of profits and capital gains according to corporation tax rules.

Sharing profits and losses

The Partnership Act 1890 states that profits and losses are to be divided equally between the number of partners unless determined in accordance with the partnership's profit sharing ratio (PSR) arrangement during that period as per the partnership agreement (if there is one).

Partnerships are not bound by a legal requirement to have a written agreement; indeed, many operate without one. However, this lack of agreement can lead to disputes and potential legal issues. One immediate issue is that partner contributions and involvement may not be equal and, therefore, do not merit an equal share of the profits.

All partnerships with a written agreement can agree to share profits on any basis they choose, varying the ratio year on year as they decide as long as it's fixed at the end of the year. The only proviso about PSRs is that it cannot be altered retrospectively which means that it is not possible to change the PSR after the year end to secure a more favourable tax-efficient outcome. However, it is possible to overcome this restriction with a flexible PSR written into the agreement e.g. including such words as ‘as the partners shall from time to time decide’.

Why change the PSR?

There may be many reasons to change a PSR but, whatever the reason, this affects all taxes payable by each partner following the amendment. The impact of any such change is that the profit or loss needs to be time apportioned as at the date of change prior to allocation.

Disputed profit share allocation

There may be instances where individual partners disagree with the allocation of profits as declared in the partnership statement (or have not received the amount shown) and would not want to be taxed on income not received.

In the First-tier Tribunal cases, Morgan v HMRC and Self v HMRC [2009], there was a dispute about profit allocation where the taxpayers had received payments on their (involuntary) departure from the partnership of which they had been members. The partnership considered the payments to have been an allocation of profits and showed them as such on the partnership tax return. However, the taxpayers disagreed with the designation and appealed against HMRC's assessment. The judge agreed that the assessments were valid and, following the cases, HMRC inserted a new section in the Taxes Management Act 1970 and updated its guidance in the Enquiry Manual EM7522, stating that 'A partner’s personal return must include the amount that the partnership statement says is their share of the partnership profit or loss'. As such, the basic rule is that a partnership return is conclusive for tax purposes not only as to the amount of a partner's share but also as to whether a partner received any share at all.

Declaration on tax return

If there is genuine disagreement that cannot be resolved before the tax return submission deadline, HMRC suggests that the partner should enter the amount of partnership profit share they consider to be correct, and make an entry in the 'Additional information/white space' notes section of the return to show the profits as allocated in the partnership statement, a deduction (or addition) of the disputed amount and an explanation about why the allocated profit amount shown on the partnership statement is wrong.