Last year’s pre-budget report will have major implications for the taxation of partners’ income. Baker Tilly’s George Bull sets out the full impact on partners, law firms and clients
In the November 2008 pre-budget report, the Chancellor of the Exchequer announced a series of changes, including tax and national insurance increases, which will affect the UK’s highest earners from next year.
Many of the changes start small but will build up over time.
From the 2010-11 tax year there will be a phase-out of personal allowances on high income, with the basic personal allowance being restricted for gross (pre-tax) incomes exceeding £100,000. The restriction will apply in two stages: up to half of the allowance for income between £100,001 and £140,000; and the balance when income exceeds £140,000.
In each case the restriction will be £1 for every £2 of excess over the threshold. Based on a personal allowance of £6,475 (the same as for 2009-10), this will increase the income tax liability of high earners by up to £2,590.
As if the phasing-out of personal allowances was not bad enough, from 2011-12 the tax burden on the highest earners will increase significantly because a new top tax rate of 45% applies to incomes of more than £150,000 as well as an additional 0.5% national insurance contribution increase.
For employees, including salaried partners under Pay As You Earn (PAYE), the national insurance increases will apply at all income levels subject to national insurance payments, working out as an additional 1%, taking employers’ and employees’ contributions together. Class 4 national insurance contribution for the self-employed will increase by 0.5%.
However, it is the 5% income tax increase that will be felt most keenly by those with taxable incomes of more than £150,000. For partners with incomes of £175,000, the tax increase will be £1,250, but do not forget the national insurance increase of £693 on top of this. The impact increases dramatically for higher incomes. On a profit share of £500,000, extra income tax of £17,500 and national insurance contributions of £2,468 will be due, producing an eye-watering additional liability of almost £20,000.
Lifetime pension scheme limits frozen until 2016
An unexpected aspect of the pre-budget report was the Chancellor’s proposal to freeze the 2010-11 pension schemes lifetime allowance and annual contribution limit of £1.8m and £255,000 respectively for the following five years. This will restrict individuals’ scope to make pension provisions, especially those who are unable to make substantial contributions in the short term but who plan to resume funding their pensions when business conditions ease.
Freezing the lifetime allowance for six years also threatens serious consequences for existing schemes. The lifetime allowance caps the value of an individual’s pension fund. If the lifetime allowance is frozen, any resurgence in investment values risks making pension funds over-funded and susceptible to the 55% charge on withdrawals that exceed the lifetime allowance.
Pension funds can be protected but the deadline for opting for protection is 5 April, 2009. If you have not already done so, you must review your current arrangements now in order to avoid missing the deadline for fund protection.
Annuities versus personal pensions
While the number of partners entitled to receive annuities from their firms on retirement continues to decline, the pre-budget report changes mean that these old-style annuity arrangements look even more attractive. Annuity arrangements are reviewed critically on mergers or LLP conversions, and often bought out at that time. The pre-budget report changes seem likely to raise the stakes in this area.
LLP or limited company?
The national insurance contribution changes proposed in the pre-budget report make it more attractive to be self-employed than a director or employee of a limited company. Partnerships considering whether to secure liability protection through an LLP or limited company are now more likely to opt for LLP status. Some firms operating through limited companies may even choose to convert to LLPs.
Many firms are part way through a period of spreading the additional profits brought into account following adoption of UITF 40 in relation to work in progress. For some, the final spreading adjustment will fall into the year 2011-12 and so is potentially taxable at 45%. Firms facing the 45% charge should bear in mind that they have the option of bringing forward the additional profit and including it in the return for 2010-11 and paying income tax at 40%. Care is required because this approach only fully benefits 45% taxpayers. In cases where the whole of the 2011-12 adjustment would have been taxed at 45%, the choice may be straightforward. However, the effect on each partner must be considered as the spreading option applies to the entire practice and is not available individually.
Income or capital gains
With profit shares subject to income tax/national insurance contributions at combined rates in excess of 45% while capital gains are taxed at no more than 18%, the attractiveness of selling one’s interest in a firm will increase. That could become a reality for law firms in 2011 or 2012, with the arrival of external equity in the legal profession following the implementation of the Legal Services Act. While the possibility of sale may be some way off, partners are already beginning to consider how capital interests in their firms should be allocated.
Barristers changing from cash basis after seven years
A barrister who has prepared accounts on the cash basis in the first seven years of practice will have to consider whether to opt for the 10-year catch-up on transition to normal accounting basis. Applying the transitional provisions may create additional tax liabilities for those subject to the 45% top rate but, in most cases, the cashflow effect of bringing forward a charge that would otherwise be deferred will be greater than the tax saving. This is one of the factors that need to be considered by any barrister approaching his seventh year in practice.
Rent for use of premises
A partner who provides business premises to his firm might consider receiving rent and a reduced share of profits because the rent is national insurance-free. However, renting property to the practice will be prejudicial to entrepreneurs’ relief from capital gains tax. That relief is only available if the property is disposed of following a withdrawal from the business and may not be as valuable as the immediate, regular saving in national insurance contributions. All the options need to be weighed up before deciding whether to charge rent.
Issues for clients
The 45% rate will not only impact on partners, it has the potential to affect a range of clients.
Trusts will generally pay the 45% tax rate on trusts, regardless of the size of the trust. For those trusts that distribute to UK-resident beneficiaries the tax paid will be available as a credit to the beneficiaries against their own income tax but there will at least be a cashflow cost and in some cases the tax will not be recoverable in full.
Non-domiciliaries who claim the remittance basis on their overseas income and capital gains will need to: