Business Clinic: Advice on fluctuating partnership capital

Whether it’s a legal, tax, insurance, management or land issue, Farmers Weekly’s Business Clinic experts can help. Here, Kate Bell of accountant Albert Goodman sets out considerations on partnership capital and income shares.

See also: Readers’ questions answered by FW’s Business Clinic experts

Q: We are partners in a 243ha mixed arable and beef farm. There are four partners – myself, my husband, and his parents. We don’t have a fixed profit-sharing arrangement; it varies each year.

Recently, my in-laws have been allocated more profit.

While this is said to be tax efficient, I’m concerned we’re not being fairly rewarded for our contributions, and our capital accounts can decrease in the year-end accounts, whereas my husband’s parents’ accounts seem to increase.

Should I be concerned?

A: Income profit sharing refers to how the business’s annual profits are allocated among partners and directly impacts each partner’s tax position.

The profit-sharing ratios can vary yearly by agreement, subject to the terms of the partnership agreement, and may include prior salary or share of profits to reflect individual contributions.

Partner contributions come in many forms: time, skills, enthusiasm or capital. Capital may include cash, land, property, livestock or machinery.

In non-family partnerships, profit sharing discussions often stop here. With family businesses where income tax planning is key, it becomes more complex.

From an accounting perspective, your current account increases with your share of profit and capital introduced during the year.

It decreases by your share of losses and drawings, including withdrawals, private expenditure, pensions or tax payments made by the business. If your drawings exceed your profit share, your current account declines.

Significance of capital and current account

A partner’s capital and current account reflects what they have invested in the partnership. While sometimes seen as a “paper figure”, it does carry weight if a partnership ceases, or a partner exits.

For example, if Jane, a partner, has a capital account of £100,000 and decides to leave, then the starting point is that she receives £100,000 on exit. 

Capital accounts may be adjusted before a partner leaves a business. If capital is to be revalued to open market value, then land value uplifts should be allocated according to the land capital ratio.

Where the general capital uplift is not clear, it may be split equally, in line with capital accounts, or even by the profit-sharing ratio, particularly if there has been past ambiguity between income and capital sharing.

A well-drafted partnership agreement and accurate accounts can help avoid disputes by setting out how capital is to be shared.

In the above case, if there is a £200,000 uplift on the value of plant and machinery and stock from the balance sheet value, that value is shared among the partners. 

If Jane is entitled to a 40% share, she gets £80,000 of the uplift (40% of the £200,000 uplift), increasing her capital to £180,000 (£100,000 original capital plus £80,000 uplift).

Capital accounts and payouts

This shows how the partners’ capital accounts have a real impact on payouts.

Where a partner’s capital is reducing, they would receive less money on leaving a partnership, and a negative capital account may mean a payment to the partnership is required.

Also, if a partner’s profit share is reduced (maybe for tax purposes) this can result in a reduced capital account and potentially a reduced uplift on leaving a partnership.

We have seen many cases where partnerships cease or a partner leaves the business, and at that point the capital accounts and profit-sharing ratios become very real and important.

The value of the capital accounts is often paid out at this time.

As with many aspects of business, there is a balance.

The partners may choose a specific profit-sharing ratio that is more efficient for income tax, but that may result in other partners having reducing capital accounts.

Partners must make informed decisions to weigh short-term income tax savings against long-term equity and tax concerns.

If partners never fall out and the partnership assets simply pass from parents to children at some point, the level of money shown in a partner’s capital or current account is less important. 

Beware IHT implications

However, business capital is part of an individual’s estate for inheritance tax (IHT) purposes. Under proposed IHT reforms, only 50% business property relief may apply, possibly triggering a 20% IHT charge.

So, income tax savings through profit allocation could be offset by increased future IHT on the parents’ estate. This highlights the need for holistic tax planning.

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