Partnership split

My clients are a husband and wife partnership and have been in business together for many years. Their partnership agreement says that the business profits are to be divided between them ‘as they may from time to time agree’.

 

Generally, once the accounts have been prepared an amount has been allocated to the wife in the manner that was most efficient for tax and National Insurance contributions purposes and matters proceeded smoothly.

 

Unfortunately, my clients separated a few months ago and are now involved in what appear to be increasingly acrimonious divorce proceedings. I have prepared the most recent accounts, but the partners are unwilling or unable to agree the profit share. What should I do?

 

I have warned the clients of the implications of the late submission of the accounts and partnership and personal tax returns, but to no avail. Interest, surcharge and penalty charges will be accruing and I am concerned that this will rebound on me.

 

Must I wait until the lawyers thrash out the divorce or is there another approach I should take? Should I simply use last year’s profit ratio or is there a default position, say 50:50, that comes into play in such circumstances?

 

Query 17,767 – Middle Man

 

Middle Man should also consider the recent article ‘Mr and Mrs Smith’ , which delved into husband-wife partnership profit sharing issues.

 

Middle Man’s statement that profits were allocated to the wife in a way that was ‘efficient for tax and National Insurance contributions’ is not too blatant. I would say that it is a consideration, but not necessarily the only consideration.

 

However, unlike a ‘wife’s wage’ from an employment with the husband that should be commensurate with her work and skills, there is little HMRC can do to disturb profit-sharing arrangements in a partnership. HMRC say in their Business Income Manual at BIM72065 that:

 

 

The settlements legislation can however be brought to bear on such arrangements, but HMRC will 

only consider this where the tax at stake is ‘significant’.

 

Turning to Middle Man’s specific question, the capital account balances in the last signed set of accounts will be evidence of what had already been agreed to date. From a practical point of view, I would prepare the accounts for client approval with the previous year’s profit split until told otherwise by the clients, then Middle Man isn’t seen to be taking sides.

 

But without subsequent agreement, then for additional profits/losses earned in the later year in the unsigned accounts, the Partnership Act 1890, s 24, gives the default position which is that:

 

 

PA 1890, s 19 states that ‘the mutual rights and duties of partners, whether ascertained by agreement or defined by this Act, may be varied by the consent of all the partners, and such consent may be either express or inferred from a course of dealing’.

 

Legally a 50:50 split under PA 1890, s 24 should be the default position – as their own partnership agreement seems silent – but if the previous history of accounts showed a consistent split to the contrary that an argument could be made that that remains the express/implied agreement.

 

Middle Man cannot submit partnership and personal returns to HMRC without them being signed, and this isn’t going to happen until his clients sort out their differences. He has correctly made them aware of the interest, surcharge and penalty implications for failing to file and pay tax.

 

Perhaps they can make estimated payments to save interest charges and penalties (possibly) on their personal returns – currently the penalties would be charged but then reconsidered once liability was known.

 

Penalties for a late partnership return (levied also on each partner regardless of their own personal return being filed) cannot be rescinded as they are not dependant upon liability – but they could agree to submit returns marked as provisional with a white space note, without accounts being completed, and with final amended returns to follow later.

 

Middle Man may also have to consider professional ethics at some point and whether it is best to act for only one party. 

 

 

A husband and wife partnership is not ended just because the couple divorce. So the partnership remains in existence.

 

For tax purposes, one of them must be the nominated partner. That partner is responsible for submitting the tax return. If they are disagreeing on everything, it is likely that they have not agreed on any change of nominated partner, so whoever was nominated retains the responsibility and right to submit the return.

 

In terms of a default position for profit-sharing, Partnership Act 1890, s 24 prescribes that the profits are shared 50-50 ‘subject to any agreement express or implied between the partners’. Partnership Act 1890, s 19 allows the terms of the partnership to be:

 

 

As the partnership split is always designed to be the most tax-efficient, it could be argued that this is the basis of the profit-sharing ‘inferred from a course of dealing’.

 

In terms of practical advice, Middle Man would be advised to put pressure on the nominated partner to make a decision. Provided that decision is reasonable, it is difficult to see how it could be challenged.

 

In terms of protecting his own position, Middle Man should generate correspondence setting out the position to his clients. He may suggest that their lawyers agree something provisionally to avoid penalties and interest, while allowing a final settlement to be negotiated as part of the divorce settlement.

 

 

I believe that in this situation, there is a danger that Middle Man might be trying to be too helpful and this could rebound on him at some point in the future, particularly as there are lawyers involved in the divorce proceedings.

 

Middle Man has a problem here because one of the two partners would be the partner nominated to sign any provisional partnership tax return and this could lead to Middle Man being seen to take sides by one of the partners. If Middle Man becomes involved in trying to determine a provisional split of the profits to prepare a partnership tax return there may be a risk of some criticism or action being taken against him in any court case.

 

Our firm’s policy in all partnership dispute cases is not to submit any partnership or individual partners’ tax returns until the partnership accounts and profit sharing arrangements have been approved by all of the partners involved in the business in the year concerned.

 

There is no default position in these situations and provided that Middle Man has clearly spelt out the consequences of not submitting the tax returns until everything has been agreed then he has covered himself sufficiently. From the query it would appear that Middle Man has issued the necessary warnings and that taking no further action at the present time is probably the best option.

 

It is important that Middle Man is very careful to remain neutral in his dealings with the two parties involved and this the overall situation does not lead to a conflict of interests as time goes on.

 

 

We had a similar case a few years ago … there is no default position. It sounds as if the wife has played little part in the business anyway and so the position for her is not likely to be the cause of much by way of penalties, etc.

 

The divorce case we had involved more equal earlier sharing of profit, the solicitors advised the wife not to sign the return or agree on the profit split until the financials had been agreed. We were then given instruction by the client and solicitors as to the eventual split … this took two years!

 

We did try to persuade the parties that time was of the essence, but it fell on deaf ears. As your clients must sign the returns you have no option but to wait, you can advise HMRC why there is a delay and this should not have any impact on your practice at all.

 

You should, however, also warn the clients of the ruling for capital gains tax if there is a partnership asset of value, it may well be that the decree will precede the financials if they press for it even though the judges prefer to agree financials before the decrees go through – this might actually be the bigger worry.

 

Believe me, during a divorce the taxman will be the last of their priorities!

 

 

In the pre-Budget report note PBRN34 dated 9 December 2009, HMRC stated that:

 

 

Therefore, in any case where there is a doubt, in order to ensure that late submission penalties of any HMRC form are not incurred, one way of circumventing this is to submit the form(s) by the due date with an estimated entry(s).

 

Obviously, the most essential point is that an explanation behind the reason for the estimation(s) is added to the additional information box, stating, in this case, the current state of play and the reason behind the need for the estimate(s).

 

As far as the division of the partnership profit for tax purposes goes, then based on what we have been informed as to how past divisions have been calculated, I would suggest using the same method, as though nothing untoward had happened. 

 

 

We are here concerned with a small husband and wife business partnership that appears to have been ongoing for a good few years. As we understand it, there is even a formal partnership agreement, but for perfectly sound reasons and legal purposes the (annual) partnership split of profits or losses have been left ‘open-ended’ (for annual determination after the accounts have been prepared/agreed).

 

Perhaps ‘the partnership agreement’ is silent on the matter of the cessation/termination of the (business) partnership, but certain events, such as the resignation, death (of either party) and other factors such as insanity or imprisonment (of either party) and/or (possibly) separation or divorce would seem to be pretty strong indicators of the cessation of any business partnership. 

 

My suggestion to Middle Man is that he now writes separately to each of his clients (possibly offering to copy in their respective lawyers) and suggesting that – while he remains willing to try to continue to act for each of them in respect to the accounts and to their separate tax affairs – it is now his responsibility to notify HMRC of the facts of their separation (for income tax and VAT purposes) and that the facts of the situation as he now understands them makes it extremely improbable for any of them to realistically continue to contend the continuance of the business partnership.

 

I would further suggest that he might indicate that from hereon it is his feeling that he proposes to maintain separate time records (for each of them) for future billing purposes and that unless he receives some clear instructions – say within the next six weeks or so – that he will send a short written note of the (probable) partnership cessation to HMRC.

 

This should crystalise minds.