Tax on LLP members drawings not covered by future profits

Tax on LLP members drawings not covered by...

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I have a (potential) client who was a member of a loss making LLP. They were entitled to take guaranteed drawings even thought the LLP was (and still is) loss making with the overdrawn members drawings account being cleared by future profit allocations once the LLP becomes profitable (obviously not guaranteed!). This was financed, as was the entire LLP, via the senior member of the LLP's initial capital. Naturally my client has never had a profit allocation and so never declared these drawings on their SA tax return.

My client has now fallen out with the senior member and resigned from the partnership.

As part of their leaving the senior partner agreed to transfer the overdrawn members drawings account from my client to the senior member of the LLP, meaning the senior member of the LLP will now be subject to tax on these amounts as and when future profits are made to cover the overdrawn account.

What is the tax treatment for my client, they have taken drawings in anticipation of future profits with the members drawings account then being transferred to another member of the LLP. They have never made a profit whilst a member of the LLP but to assume that the drawings are tax free (essentially a gift from one member to another) feels wrong.

Thanks,

Ron

Replies (29)

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By johngroganjga
27th Aug 2015 14:28

What does the partnership tax return say?  Are you sure it doesn't deal with what you describe as a transfer of drawings as an allocation of profit? 

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Replying to kesavalowes:
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By RMB
27th Aug 2015 15:39

Nothing on the partnership return

The partnership tax return (drafted but not yet submitted) just allocates current year losses to the senior member. No notification of the transfer between parties. I am told that as and when profits are made they will be allocated to the senior partner (the LLP deed requires allocation to overdrawn drawings accounts as a priority).

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By Justin Bryant
27th Aug 2015 15:49

To assume that the drawings are tax-free

Does not seem wrong at all in my view. Where in UK tax law does it say that anyone should pay tax on a loss making business? If a particular partner was allowed to run up a tax-free overdrawn current account, then that is his good fortune I think (assuming it was a bona fide arm's length deal). I am very happy to be proved wrong if someone can cite some legislation or case law to the contrary.

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Replying to johnhemming:
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By User deleted
27th Aug 2015 16:36

TCGA s.59

Justin Bryant wrote:
 Where in UK tax law does it say that anyone should pay tax on a loss making business?

Regardless of the loss, if the partnership has some value, then on resignation there is a disposal of his share in the partnership, for the leaving partner

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By johngroganjga
27th Aug 2015 15:54

I think the senior partner has failed to take advice on how to get tax relief for the outgoing partner's drawings now debited to him.  The result is that affairs have been arranged so that he doesn't. The corollary of that is that your client escapes tax.

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Replying to Paul Crowley:
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By RMB
27th Aug 2015 16:48

I agree

johngroganjga wrote:

I think the senior partner has failed to take advice on how to get tax relief for the outgoing partner's drawings now debited to him.  The result is that affairs have been arranged so that he doesn't. The corollary of that is that your client escapes tax.

 

My understanding is that the senior partner understands that in the future (assuming a profitable business) he will not get any tax relief and indeed will end up paying more tax as he will pay tax on the outgoing partners previous drawings. I don't know whether he took tax advice over this but it appears to be majorly in my clients favour. I just couldn't mentally get around that someone could be allowed to draw money out of a business and never pay tax on it!

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By Justin Bryant
27th Aug 2015 16:21

Also
If the LLP goes bust within 2 years, the overdrawn current account can be clawed-back by a liquidator I think.

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By johngroganjga
27th Aug 2015 16:28

But the outgoing partner's current account is not overdrawn any more - it's been repaid by his very generous and ill-advised former senior partner.

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By Justin Bryant
27th Aug 2015 16:53

I was

Clearly talking about revenue losses (and he may not have had a capital share anyway), so I assume I am right that there is no tax law to the contrary. Noted re ill-advised SP.

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By Paul D Utherone
28th Aug 2015 09:25

For SA purposes

you cannot have a partner with taxable profits and another with losses. The tax profits need to be allocated to the tax loss making partners to reduce their loss in the partnership return.

For the retiring partners tax return there will be no taxable income. Probably the remaining partners need to address this like a deferred tax adjustment in making the payout so that the retiring partner has a notional tax charge on the prior share of profits within the firm and that balance carries and will release to the remaining partners in the future when profits arise and tax becomes payable as the PY losses unwind

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By johngroganjga
28th Aug 2015 09:36

I though the rule worked the other way round. No partner has tax loss for tax purposes unless there is a loss overall. News to me that the mirror image is also the case - no partner has profit for tax purposes unless partnership as a whole makes a profit.

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By Paul D Utherone
29th Aug 2015 01:18

I think there is a loss overall isn't there?

Whatever it is, profit or loss, you cannot have some partners showing a tax adjusted profit and others a loss. For tax allocation purposes there has to be an equalisation so that a partner with a profit and others with an enhanced loss, or vice versa ends up with zero profit/loss for tax purposes and the others loss/profit is adjusted accordingly.

So as posted it would seem to be as I suggested and the retiring partner's prior share of profit gets adjusted down to the partnership taxable profit (assuming all other partners were expecting a tax adjusted loss) or zero, and the others losses are adjusted correspondingly.

That being so they may as suggested wish to make internal deferred tax adjustments to reflect the changes required to the allocations they would otherwise have expected

Edited for typos

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By johngroganjga
28th Aug 2015 15:36

So you are saying that my understanding that it only worked that way for losses is mistaken?

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Replying to Paul Crowley:
By Paul D Utherone
29th Aug 2015 01:14

Yes

johngroganjga wrote:

So you are saying that my understanding that it only worked that way for losses is mistaken?


 I am
 - see ITTOIA s850 - www.legislation.gov.uk/ukpga/2005/5/section/850
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Replying to Wilson Philips:
By johngroganjga
29th Aug 2015 09:46

Losses

Paul D Utherone wrote:

johngroganjga wrote:

So you are saying that my understanding that it only worked that way for losses is mistaken?


 I am
 - see ITTOIA s850 - www.legislation.gov.uk/ukpga/2005/5/section/850

And you are quite right of course. I had simply never come across the issue this way round. I am still baffled as to why the law foists this nonsense on us. Why does it require that sometimes one partner pays tax on another's profit or claims tax relief for a loss that another partner has suffered. In relation to the reallocation of losses when there is a profit overall I was once told that the reason for it was to combat artificial avoidance. I never quite understood what avoidance it would prevent. But in the case of reallocating profits when there is a loss overall I am even more mystified.

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By User deleted
29th Aug 2015 08:32

From what I have read, the picture, as it appears to me, is as follows:

1. Let us say there are 4 partners in the ratio of 94% : 2% : 2% :2%

2. The firm is making losses, and the loss allocation for tax purposes will follow the same ratio. Simples.

3. One of the junior partners' withdrawals (sort of remuneration) have created a drawings account with a debit balance of, let us say, £10,000

4. This junior partner leaves the partnership. At this point the senior partner accepts that the leaving partner needn't pay anything back. As a result:

a) the leaving partner's share of 2% is bought by the senior partner and his drawings will be assumed to be the payment made for his share of the partnership. The leaving partner's losses will go on his tax return as usual and he will have received a consideration of £10,000 for having given up his share in the firm. As a consequence the drawings a/c of the senior partner gets debited and the leaving partner's drawings a/c credited.

b) the firm will be reconstituted with the remaining partners 96:2:2.

The senior partner is paying £10,000 simply because he believes that the firm has a value on that date worth £500,000 (10,000/2%).

An alternative scenario would have been the firm saying the leaving partner needn't pay the drawings back, and in the processing getting reconstituted with a goodwill a/c.

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By Paul D Utherone
29th Aug 2015 10:19

If there are losses overall on the partnership comp

then you wouldn't expect in most cases a partner to be taxed in his notional partner business on a profit where none had been earned by the partnership as a whole. The partnership as a whole has made a loss and to have a partner being taxed on a profit would be counter intuitive.

Similarly it could not be correct to be able to engineer allocation of a tax profit in a business by, say, bringing a HR taxed employed spouse into a business making modest profits as a partner, then allocate a greater prior share of profit to the other spouse running the business who might otherwise waste PA's & BR band so that the employed spouse taxable at HR ended up with a tax loss they could set of sideways.

Any adjustment to the allocation of overall tax profit/loss to reflect s850 can only be by way of an internal adjustment within the partners tax accounts and deferred tax on agreement between the partners, which may be problematic in the OP's case if there has been a falling out and if litigated would have to be down to how the partnership deed says that tax reserves etc. should be handled.

It ought to be equitable to make some adjustment for the fact that the retiring partner has received drawings, but not actually been taxed on those drawings because of the s850 adjustment required to allocations. But if the partnership has been loss making, so no tax has ever been payable, and may or may not get into profit in the future and become taxable, and bearing in mind the possible future loss of PA's for continuing partners depending on future profits, a crystal ball and negotiation will be required.

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Replying to Ian McTernan CTA:
By johngroganjga
29th Aug 2015 13:33

Counter-intuitive?

Paul D Utherone wrote:

then you wouldn't expect in most cases a partner to be taxed in his notional partner business on a profit where none had been earned by the partnership as a whole. The partnership as a whole has made a loss and to have a partner being taxed on a profit would be counter intuitive.

If you think it is counter-intuitive for a partner who has had profit credited to his account to pay tax on it we will have to agree to differ!

I understand that the mischief being attacked by this provision is artificial anti-avoidance, but a measure which produces these absurd results in a straightforward (but admittedly rare) case is either a sledgehammer to crack a nut, or throwing the baby out with the bath water, or both.

Yes the anomalies can be corrected, with agreement, by internal book-keeping adjustments, but ideally, surely, the tax system should not create these anomalies in the first place.

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Replying to lionofludesch:
By Paul D Utherone
29th Aug 2015 16:52

But

johngroganjga wrote:
Paul D Utherone wrote:

then you wouldn't expect in most cases a partner to be taxed in his notional partner business on a profit where none had been earned by the partnership as a whole. The partnership as a whole has made a loss and to have a partner being taxed on a profit would be counter intuitive.

If you think it is counter-intuitive for a partner who has had profit credited to his account to pay tax on it we will have to agree to differ!
  if there's a tax loss overall in the partnership then the business has no profit to tax, so a mismatch in allocation caused by the splitting mechanism in the partnership deed is something else, but not income that should be taxed in a partner's notional trade for SA purposes.

Similarly if there is a profit for the partnership, but because the partnership deed says one or more perhaps junior partners have a larger prior share to profit - 'salary' - then you would otherwise be taxing more profit than is taxable on the business as a whole earlier than you should, or might ever need to, and possibly allowing a sideways set off of a notional loss that could be artificially fixed

 

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By Marion Hayes
29th Aug 2015 15:49

Commoner than you may think

I came across this frequently when dealing with large partnerships with adjustments for seniority, partners salaries, partners expenses, progressive profit share increases etc.

A partnership overall can only be taxed on the total taxable profit or loss for the year.

These provisions are to prevent manipulation of artificial loss claims e.g. a partnership with £10,000 profit, where one partner had a prior share of £25,000, would allow the other partners to claim their percentage of a loss of £15,000 , unless these adjustments are made. The bigger the figures the higher the created loss.

The posters assumption that the senior partner will pay tax on those drawings is not necessarily true. Partners are taxed on their profit share for a year irrespective of any previous transactions within the accounts. It is important to remember that the drawings made were not profits at all. The business has not yet made any. All that has happened so far is that the partners have agreed within themselves to take a withdrawal of capital to tide them over until profits start to top up the capita accounts to compensate. 

 

 

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Replying to jonibarnes:
By johngroganjga
29th Aug 2015 16:07

Artificial

Marion Hayes wrote:

These provisions are to prevent manipulation of artificial loss claims e.g. a partnership with £10,000 profit, where one partner had a prior share of £25,000, would allow the other partners to claim their percentage of a loss of £15,000 , unless these adjustments are made. The bigger the figures the higher the created loss.

Yes but the problem is that when the profit and loss shares are not artificially manipulated, just the natural result of applying the commercial arrangements partners have entered into with each other in good faith, they produce the absurd result that the tax does not follow the money.

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By johngroganjga
29th Aug 2015 17:11

I think you are looking at the partnership as a whole rather than the position of each individual separately. So you are failing to see the wood for the trees. Anyway enough said. We know what the law says. It's whether it makes sense that is dividing us.

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Replying to I'msorryIhaven'taclue:
By Paul D Utherone
31st Aug 2015 11:05

Yes, I am looking at the partnership business

johngroganjga wrote:
I think you are looking at the partnership as a whole rather than the position of each individual separately. So you are failing to see the wood for the trees. Anyway enough said. We know what the law says. It's whether it makes sense that is dividing us.
not the partners notional business for SA purposes, and the possibility of a partner being taxed on more profit than the business has returned - and yes I do realise that there will be a balance in the other partner(s) having a reduced profit, or possibly a loss on their return. Perhaps less of an issue post SA, when overall in the life of a business the profits are taxed only once, than it was on the PY basis with profits dropping out of account but still if the business has made 100 but a partner draws and is taxed on 200 that can't be correct can it? 100 is business profit and 100 is something else, probably an overdrawn partner account, but then in the OP's case that is going to be forgiven by other partners.

...and that's me done as well :)

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Replying to DJKL:
By johngroganjga
01st Sep 2015 21:54

Rhetorical question?

Paul D Utherone wrote:

[... but still if the business has made 100 but a partner draws and is taxed on 200 that can't be correct can it?

Drawings don't come into it by the way - it's profit or loss credited or debited to the account from which the drawings are taken.

But the answer to your question, which may have been intended to be rhetorical, is that of course it can be right for a partner whose account has been credited with a profit to pay tax on all of it, and not to offset against it a loss he has not suffered. Likewise it is only right that a partner who has had a loss debited to his account should obtain tax relief for that loss and not have it taken away from him and given to another partner who has not suffered it - adding insult to injury you might even say.

Whether it's right for these normal principles to be suspended to prevent artificial avoidance is the real question. You position seems to be that the rule is intuitively right anyway, which I find baffling in the extreme. 

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By Stuart.thomson
01st Sep 2015 22:44

Ok if I can summarise (and please correct if. I have git it wrong).

The client has withdrawn cash as drawings when there is no profit to withdraw.
This is therefore a withdrawal of capital.
No income tax is therefore due as it is not a revenue item.

However is there not a capital and so CGT issue here. The client had an investment in a partnership and has had a reduction (ie disposal) in that investment. At the point of capital withdrawal this is probably a £ for £ reduction so no CGT (unless it is greater than his investment) but on surrendering his partnership interest does he not have an investment disposal which would be a capital loss?

Ie the non-taxed income is actually a capital receipt and the resulting exit a capital loss. But the relief for a LLP loss is the net capital invested so actually it is not tax free (if the withdrawal p is greater than the investment) after all but a capped capital loss.

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By johngroganjga
01st Sep 2015 22:56

He hasn't lost his capital (if he had any - we are not told) he's taken it out - and more besides! That is why his account is overdrawn.

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Replying to lionofludesch:
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By RMB
03rd Sep 2015 09:45

Summary

Thanks for all the responses, you go away for a long weekend and come back to a screen full!

In summary, as far as I know;

- client put minimal capital into LLP (and so was a junior partner with approx. 1% interest in the LLP). Accounted for as 'capital account'

- client took regular drawings out of LLP, these were accounted for against a distribution account

- LLP never made profits, all losses allocated to senior partner

- So immediately prior to leaving client had small positive capital account, largeish negative drawings account and no taxable profits/losses allocated. Senior partner had large positive capital account, no drawings and taxable losses carried forward.

-I understand break up of the partnership wasn't amicable and in my clients words 'senior partner didn't want him involved at all going forward, even as a tail member (LLP deed that I've seen keeps resigning members as tail members with future profits of the LLP first allocated to tail members until their overdrawn drawings account is cleared)

-On break up my client and senior member entered into agreement whereby negative balance on my clients drawings account was transferred to senior member. Senior member apparently aware that they will be taxed on this in the future as and when/if LLP makes profits.

- My client received their full capital amount back from the LLP and all ties are now severed.

So client will never have taxable profits (or losses) allocated to them and so I don't believe the historic drawings will ever be taxed. There is then the question as to whether the write off is taxable as capital (as amount written off was in excess of clients capital by a long way). Issue is that the business is a loss making start up with little or no value and definitely not worth anywhere near the value the write off of the drawings account would imply given clients approx. 1% interest). The write off/transfer of the drawings account was purely a commercial agreement between client and senior partner in order to make a clean break.

My reading of the above answers is that despite the write off being well in excess of the value of my clients capital invested in the partnership this will be a capital gain for them?

 

 

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By johngroganjga
03rd Sep 2015 09:58

I disagree.

Your client has received a tax free credit to his drawings accounts. How that is dealt with within the LLP is an internal matter for them, but even if they call it a profit allocation it is not taxable on him as the LLP as a whole made a loss. 

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By Harrylp
15th Feb 2021 06:15

Hi,
How did this pan out?
I have a similar situation coming up.
Thanks

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