Using a Corporate Partner To Avoid Tax

With the rise in the rate of income tax from 40% to 50% next year introducing a corporate partner could be an option for any partnerships looking to reduce tax. How are partnerships taxed? Partnerships are treated as transparent entities for tax purposes. This applies both for income tax and capital gains tax. The effect of this is that:

Trading profits of the partnership are calculated based on the usual rules of deductibility and are then taxed on the individual partners. Therefore whilst the partnership would need to file a tax return showing the partnership profits, those profits would then be apportioned to the partners and would entered in their self assessment tax return. Income tax would then be payable by the partners. The partnership profits are allocated in accordance with the profit sharing ratio.

Capital gains of the partnership are also allocated to the partners and taxed as part of their tax return. LLP's Limited Liability Partnerships ('LLPs') were introduced in 2001 and offer a cross between a partnership and company structure. They were mainly introduced to offer large professional firms that trade as partnerships (accountants, lawyers, surveyors etc) the opportunity to benefit from limited liability, as a company can. An LLP is simply a partnership, which provides the partners with the benefits of limited liability - thus ring-fencing their personal assets from any potential business creditors. Although in general law a LLP is regarded as a 'body corporate'and is like a company, for tax purposes a LLP is normally treated as a 'partnership'. Therefore an LLP will normally be regarded as transparent for tax purposes and each member/partner will be assessed to tax on their share of the LLP's income or gains as if they were members of a 'normal' partnership. Thus if a LLP carries on a trade then each registered partner is taxable on the income they derive from the LLP as trading income. This is a crucial difference from being a shareholder in a company. A company shareholder is regarded as a separate entity for both legal and tax purposes. An LLP however is a separate legal entity purely in legal terms. Therefore a company shareholder is not taxed on the profits of the company, just the cash that is extracted from the company (either as salary/benefits or dividends). A member of an LLP is however taxed on his or her share of the profits that are generated by the partnership. For a higher rate taxpayer they would therefore pay 40% income tax on the LLP profits 9or 50% after April 2010), whereas a company may pay corporation tax at a lower rate (21/29.75/28%). What's the problem? There are two key problems: Firstly, the partners will be subject to income tax at 50% as from April 2010 where their share of the profits exceeds £150,000. Secondly, there is no opportunity to avoid tax by retaining it in the partnership. All the trading profits will be taxed on the partners as they arise - irrespective of whether the profits are retained in the partnership or not. One option to mitigate these problems is to use a corporate partner. Using a corporate partnership Using a corporate partner simply means that you will use a company as one of the partners. The corporate partner will usually be owned by the existing partners. The benefits of using a corporate partner are:

Profits in excess of £150,000 for each of the partners can be voted to the corporate partner. This would then allow profits above the new 50% tax band to be allocated to the company and the 50% tax rate could be avoided. The corporate partner would be subject to corporation tax at rates between 21% and 28%.

The company could hold the cash and avoid any further tax charges on the extraction of the profits. Of course the cash in the company would need to be extracted at some point in the future and if you wanted to do this tax efficiently you could consider:

Becoming non UK resident and extracting cash as a dividend free of UK income tax

Becoming non UK resident and extracting cash as a capital distribution. This would be free of UK capital gains tax providing the shareholder was non UK resident for at least 5 complete tax years.

Simply extracting as a capital distribution. If you wanted to extract as a capital distribution you would need to wind up the company and extract the cash during the course of the winding up. The CGT rate would then be 18%. Entrepreneurs relief could be due if the company was a trading company (to reduce the effective CGT rate to 18%) however this would be unlikely to apply if the company was simply receiving a share of the partnership profits.