Congratulations on becoming an equity partner! We need to talk about Tax

 When you join a partnership, you cease to be an employee and are classed as self-employed.  Here are eight short points to help you understand how you are now taxed and some tips to help you benefit from your new status.

1. Income

Your income tax is no longer collected by your employer through the PAYE scheme.  Instead, you must complete a tax return each year, declaring your share of the partnership’s taxable profit and the tax you owe on this profit and any other income you receive.

The partnership’s taxable profit is different from the accounting profit because some expenses in the accounts are disallowed for tax purposes.  This includes depreciation, client entertaining and any personal expenses paid by the partnership, such as motor expenses.

2 Drawings

Instead of receiving a salary, you are likely to have arranged a monthly payment to your bank account.  This is treated simply as an advance of your profit share and is not reported on your tax return. The main distinction here is that you are taxed on the whole of your profit share regardless of whether you have received all of it in cash or left a part in the business to fund working capital or future growth. You will also need to remember to save for your tax bill! if your firm is not retaining some of your profit share in a separate tax reserve.

3. Allowable expenses

As a partner, if you incur business expenses personally and are not reimbursed by your practice, you may be able to deduct these from your taxable profits and reduce your tax bill.

4. Motor running costs

If you have a car or motorbike which you use for work you can claim the business proportion of the running costs, such as servicing, repairs, fuel, road fund licence, MOT, insurance and any interest on finance leases.

5. Funding of capital

If you borrow money to buy into the practice, or invest capital in the future you can claim a deduction for the interest paid on the loan.

6. Working from home

If you work from home, you can claim for the business use of your home telephone and broadband, as well as utility bills and mortgage interest.

Other common expenses likely to attract tax relief are computers, bike, books and journals, professional subscriptions, stationery and training courses.

Paying tax – a worked example

In general, you pay tax on your profit share for the accounting year which ends during the tax year.  For example, if your partnership’s financial year ends on 31 December 2018, then your profit share from this year will be included in your tax return 2018/19.

Your tax liability is paid in 3 instalments:

31 January 2019

First payment on account (an estimated amount based on your 2017/18 tax liability)

31 July 2019

Second payment on account (as above)

31 January 2020

Balancing payment arising from the final calculation on your tax return 2018/19.

In your first year of self-employment, it is likely that there will be no payment on account (unless you have previously had other taxable income to declare).  Instead, you will pay tax on the proportion of the first year up to 5 April.

In our example, if you became a partner on 1 January 2018, your first tax return will be due for the tax year ending 5 April 2018.

This will include 3 months’ profit share for January to 5 April 2018.  The tax arising on this income will be due for payment by 31 January 2019.

For tax year 2018/19, you will be taxed on your profit share for the 12 months ending 31 December 2018.  There may be small payment on accounts due on 31 January 2019 and 31 July 2019.  On 31 January 2020, a potentially substantial tax liability becomes due.  The balancing payment from the first 12 months profit is added to the first payment on account for the year ending 31 December 2019, which is 50% of the total tax liability for 2018/19.  You can see that having paid very little tax since you became self-employed on 1 January 2018, you may be facing a significant bill in January 2020, and you will be wise to make provision to pay this during this period.

In our example, you can see that three months’ profits have been taxed twice.  This is referred to as overlap profits.  When you retire from the partnership, your overlap profits are deducted from your final profit share, so that you are only ever taxed once on each profit share.  However, depending on the current tax rates prevailing and your own personal circumstances, the rate of tax paid can vary significantly.

Other opportunities to reduce your tax bill

7. Pension contributions

Any contributions to a personal pension plan will attract relief at your highest rate.  In 2018/19 the higher rates are 40% and 45%, but if your income falls within £100,000 and £123,700 your marginal rate is 60% with the loss of your personal allowance.

For example, suppose your income is £120,000 and you decide to make a gross pension contribution of £20,000.  You will pay a net contribution of £16,000 to your pension fund and your fund receives the other £4,000 directly from HMRC.  You will receive further tax relief of £8,000 via your self-assessment tax return.  So your pension fund increases by £20,000 at a total net cost to you of £8,000.

8. Donations

Any gifts to registered charities will also reduce your tax liability by extending your basic rate band.  For example, if you donate £800 on your tax return this is grossed up to £1,000 and your basic rate band is extended by this amount.  If you are a higher rate taxpayer this will reduce your tax payable by at least £200.

Conclusion

All of the above is a brief overview of some of the main remuneration issues that you need to be aware of when becoming a self-employed partner for the first time.  We would encourage you to speak to an accountant or tax adviser to find out more.

Hilary Evans, Hazlewoods LLP