Recently I had the opportunity to speak at a Partnership Tax Conference on the subject of Partnership Losses. One would normally think that partnership losses are a minority sport which are only relevant for the bad days. It never ceases to amaze me the number of occasions that partnership loss planning is necessary, even on a successful project. Typically it might be that the priority share partners have such a large guaranteed profit share that the project can return a profit but after payment of guaranteed profit some partners experience a loss.
Tax allocation across the partners
If the partnership is operating a trade in the UK then the first task is to reallocate profits and losses so that no partner can be receiving a share of loss whilst others are taxed on profit. This is a tax allocation and not related to drawings. The practical implication being that it is possible for a partner to be entitled to profit (for example due to a guaranteed profit share) but have no tax liability as they have had another partner’s loss allocated to them. Very rarely do partnership agreements consider the extent that one partner compensates the other for the tax which the former does not need to pay. Even if there was a compensation clause in the partnership agreement then the debate moves to a fair mechanism to determine the compensation. Should it, for example, be the amount of tax that the benefiting partner does not pay? If so, when should the payment be made? For example should it be at the time that the benefiting partner would have ordinarily paid tax to HMRC?
Once the loss has been reallocated then each partner is free to do with their share of loss what is appropriate for them.
If a partner was joining a new partnership or a new partnership was commencing then losses of the partner in the first four years of assessment could be carried back against total income of the three years prior to the loss making year. The carry back is on a first in, first out basis and so is carried back to the earliest year possible. The loss can be set against total income of the earlier year.
Terminal loss relief
Conversely losses in the last 12 months of trade, including an impact of overlap relief, can be carried back against to the previous three years. This is often called terminal loss relief and, unlike opening years loss relief, the loss can only be offset against profits of the same trade of the earlier years.
Sideways loss relief
The most common use of partnership losses is sideways loss relief which is an offset of losses against total income of the same tax year or total income of the previous tax year. The loss can also be offset against total income of both of those two years in which case the taxpayer can elect which year the loss is first used against. If the partner is in the early years or the last year of a trade then sideways loss relief can be claimed in addition to opening years and terminal loss relief.
Sideways loss relief and opening years loss relief are an offset against total income. Terminal loss relief is only against previous profits of the same trade. There is a restriction on use of losses against total income to the greater of £50,000 and 25% of total income of the profitable year. This is a general cap on certain reliefs, not just losses. In addition to the general cap there are specific caps which apply to losses. They are relevant if the partner is not active in the business or has little capital at risk in the business.
Non-active is defined in legislation. If this restriction applies then there is a cap of £25,000 use of the loss.
Certain partners are restricted in their use of loss to their capital contribution into the partnership. Essentially this is to cap the loss to the amount of their risk capital and this legislation is designed to reduce the scope for partners claiming losses where they have little economic downside of being a partner.
Offset against Capital Gains
As an alternative to using a trading loss against income then a partner can offset the loss against capital gains of the same tax year as the loss is recognised. Economically this relief is available to help partners who finance a loss making partnership by a sale of capital assets. With capital gains tax rates being lower than income tax rates then the partner needs to consider if it is beneficial to use an income tax loss against a capital gain.
In summary loss planning is more common than most people appreciate and losses need to be considered in detail as there are many restrictions on their use. Conversely they can be used flexibly and this leads to planning opportunities.