Forming a partnership to split your income

What’s mine is yours

Splitting income with your spouse or civil partner to reduce your tax bill is probably the most common form of tax planning. The trouble is HMRC scrutinises such arrangements. Typically, it attacks income splitting arrangements that involve one spouse paying the other a salary for no good reason or paying them the lion’s share of dividends. By contrast, HMRC rarely attacks arrangements where profits are diverted to a spouse by making them a partner in a business.

Partnerships

In English law (it’s different in Scotland), a partnership is created simply by two or more persons sharing business profits. This makes it difficult for HMRC to dispute the existence of a partnership and, consequently, the allocation of profits between the partners. In fact, HMRC’s internal guidance says, “It may be possible in these cases to challenge the spouse or civil partner’s status as a partner, but such a challenge is often very difficult to sustain.”

You must draw up a partnership agreement to formalise the arrangement, otherwise there is a greater risk of HMRC challenge.

A green light from HMRC

Having cleared the initial hurdle of creating a partnership, you might still be concerned that HMRC could attack the arrangement where you split the profits with your spouse simply to avoid tax. Surprisingly, HMRC’s guidance helps out again. It says, “A spouse or civil partner is sometimes taken into partnership wholly or mainly to maximise the benefit of the tax reliefs that are available”, it continues, “It is worth emphasising that a partnership is not a sham merely because it is set up to save tax” and “You cannot challenge the apportionment of profits, as you can a wage, by reference to the value of the partners’ contribution to the firm’s activity”.

While HMRC can’t do much about splitting profits, it can limit tax relief for partnership losses. Special rules limit income tax loss relief for partners who are not active or have limited input into the business.

HMRC’s generally relaxed attitude to partnerships is tempered by the so-called settlements legislation. It allows HMRC to block tax savings by treating the profits allocated by the partnership to a spouse who’s not active in the business as taxable on the other spouse.

The good news is that this type of attack is fairly simple to rebuff as the settlements legislation can only apply if the inactive partner is only entitled to income, i.e. a share of the profits, but not a share in the partnership’s capital assets, e.g. goodwill etc. Providing you can demonstrate that your spouse is entitled to a share of the partnership’s capital assets the settlements legislation won’t bite.

Set out each partner’s entitlement to income and capital in your partnership agreement.