Tax Talk: Mixed membership partnerships: beware the complex rules
We look at the pros and cons of having a corporate partner in the mix, and the additional care needed for their tax reporting.
Mixed membership partnerships are subject to wide-ranging rules that allow HMRC re-allocate excess profit from the corporate partner to the individual partners for tax purposes.
So why have a corporate member in the partnership? One obvious reason is that the rates chargeable to tax for corporate and non-corporate members are very different. The Corporation Tax (CT) rate is currently 25% for companies with a profit over £250,000 (up from 19% in April), but is still only 19% for those with a lower profit. The rate is still very low compared to Income Tax (IT) applicable to individual partners, which starts at 20% but can be as high as 45%. What’s more, individuals with trade income will be hit by Class 4 National Insurance, currently at the rate of 9% for income between £12,570 to £50,270 and 2% on the excess.
Another advantage of a hybrid structure is that it provides more flexibility on how individuals are remunerated and on the timing of extraction of profit from the company. This means more tax planning opportunities for minimising liability.
What are the tax planning opportunities?
Tax planning opportunities are available by deferring the payment of tax. This is a particular benefit where there’s a need to retain cash in the corporate entity and delay the timing of its extraction from the business. Unlike an individual partner being taxed on their share of partnership profit, irrespective of whether or not it has been withdrawn from the partnership, the employees or the shareholders of the corporate entity will be charged to tax only on the eventual extraction of the company profit.
Tax on profit: individual vs corporate member (using current tax rates and assuming all the individual members are higher rate taxpayers).
|Tax on:||individual partner||corporate partner|
|Tax adjusted profit||100,000||100,000|
|Income Tax at 40%||(40,000)|
|Class 4 NICs at 2%||(2,000)|
|Corporation Tax at 19%||(19,000)|
|Profit after tax||58,000||81,000|
|Effective rate of tax||42%||19%|
RRORS in table
So, there’s definitely a cash flow advantage in having a corporate member and retaining the partnership profit by deferring payment of tax. This is important where cash is required for funding working capital or future capital injections to the LLP. But note that there will be a further charge to tax on the eventual extraction of profits.
Mixed membership partnership rules: when do they apply?
So, what are these rules about? The legislation was introduced on 6 April 2014 alongside the salaried member legislation (for more detail on the latter, see the November 2022 edition of Tax Talk).
It is for all UK partnerships, LLPs and foreign entities that are treated as partnerships for UK tax purposes, with ‘mixed members’ (a combination of individual and corporate members) . This legislation only applies when there are tax-motivated arrangements in place, between individual and corporate members, in allocating profits and losses in such a way that reduces the overall tax on their share of partnership profit.
Broadly speaking, tax-motivated arrangements are those where partnership profits are allocated to a corporate partner in circumstances when the individual member receives the benefit from the allocation.
Not surprisingly, the rules are not restricted to profit-making partnerships. In a loss-making year of a partnership, the tax-motivated arrangement is made so that partnership losses are allocated to the individual partner(s), instead of the corporate member. This enables the individual partner(s) to access the reliefs from the loss allocations.
So it was to prevent this kind of tax avoidance that the mixed membership rules came into force in 2014.
The impact of the mixed partnership rules
So, what are the implications? In a nutshell the provisions take partnerships back to the original position before any tax-motivated arrangements are made.
The rules affect excess profit allocation. The tax-motivated arrangements made to secure a tax advantage on the partnership profit allocation to the corporate member, above their genuine share of partnership profit acting at arm’s length, will have to be reallocated to the individual partners.
As a result, the individual partners will have to pay Income Tax on the reallocated profit from a corporate member.
Equally, the corporate member will recognise a corresponding reduction in their taxable profits, and any distributions made to the company (with the tax-motivated arrangements) are ignored for tax purposes.
The overall tax impact from this excess profit allocation is that the rate of tax on a corporate member’s profits that were originally allocated, and are now to be reallocated to an individual member, will be more than double: from as little as 19% for the corporate member to as high as 47% for the individual member.
How to report mixed membership partnership taxable profit/(loss) calculations
In a mixed membership partnership, two computations of taxable profits must be carried out. One under the IT rules relating to individuals, and the second under CT rules relating to the corporate partner. This means there will also be two reportings of the partnership results, calculated using both IT and CT rules. The individual member taxable income is calculated under IT rules, and the corporate member’s income under CT rules.
What next for partnerships?
Mixed membership partnership tax reporting is not an easy area of law and has become a key focus for HMRC. HMRC has been sending more communications to partnerships regarding their compliance with the Mixed Members rules in recent years. The objective of the rules may well be to tackle tax avoidance, but even commercially minded taxpayers now bear the brunt of the rules’ complexity.
It’s increasingly important for taxpayers involved in mixed membership partnerships to invest more time in identifying and documenting the evidence to demonstrate their calculations and profit share entitlements from the partnership. Above all, care should be taken to ensure that profits allocated to the corporate partner are commercially justifiable.
The information in this article is intended for general guidance only. It should not be regarded as comprehensive for decision-making purpose. If you would like advice or further information on any of the above, please contact Tilak Lamsal or Stephen Kenny.