How profits are calculated and shared in a UK partnership, from the basics to salary and interest on capital.
ITTOIA 2005 ss.849-850 · TMA 1970 s.12AA
What Is a Partnership? (And Why Does It Matter for Tax?)
Imagine three friends, Priya, Sam, and Dev, who open an engineering consultancy together. They are not employed by a company. They do not pay themselves a wage through a payroll. Instead, they share whatever the business earns. They are in a partnership.
A partnership is legally defined by the Partnership Act 1890 as “the relationship which exists between persons carrying on a business in common with a view to profit.” In plain terms: two or more people running a business together, sharing what it makes.
Here is where it gets interesting for tax purposes. A partnership is not a taxpaying entity. Unlike a limited company, the partnership itself does not pay tax. There is no such thing as a “partnership tax bill.” Instead, each individual partner pays income tax on their own share of the profits through their personal self-assessment return.
Key rule: A partnership files an annual information return (under TMA 1970, s.12AA) to record how profits are split. The actual tax liability sits with each individual partner, not the partnership.
The Partnership Agreement: Why It Has to Be Written Down
A partnership can legally exist without a written agreement, but that is a risk most advisers would not recommend. Without one, the Partnership Act 1890 applies by default, which means profits are split equally regardless of who works harder, who contributed more capital, or who brought in more clients.
A well-drafted partnership agreement covers:
- How profits and losses are divided between the partners.
- How a new partner joins the firm.
- How a partner retires, including notice periods and any goodwill payments.
- What happens when partners disagree.
- Who owns which assets of the business.
The agreement is also the document that defines the profit-sharing ratios, partner salaries, and interest on capital, all of which directly affect the tax calculation. Without it, none of those allocations have a legal basis.
Types of Partner: Not All Partners Are the Same
The word “partner” gets used loosely. For tax and legal purposes, there are four distinct types.
Full Partners (Equity Partners)
These are true partners. They share in the profits when the business does well and share the losses when it does not. They play an active part in running the firm. Their profit share is taxed as self-employment (trading) income.
Salaried Partners
This one catches people out. A salaried partner appears on the letterhead and has “partner” in their title. But internally, they receive a fixed salary and have no share in the profits or losses. For tax purposes, their salary is treated as employment income. They are effectively a senior employee and a cost to the equity partners.
Watch out: Salaried partners are NOT equity partners. They are excluded from profit allocation calculations. Their “salary” is employment income, not a prior profit share.
Sleeping Partners
A sleeping partner invests in the business and shares in profits and losses but plays no role in running it. They are passive investors. Their profit share is still taxed as trading income.
Limited Partners
Similar to sleeping partners, but with one key difference: if the business makes a loss, a limited partner’s liability is capped at the capital they originally invested. There must always be at least one partner in the firm with unlimited liability.
For CTA exam purposes, the focus is on full equity partners. Salaried partners are excluded from partnership tax computations.
The Three-Step Framework
Every partnership tax calculation follows the same three steps. Learn this structure and you can handle any scenario.
Step 1: Adjust the Accounting Profit
This is identical to the adjustment for a sole trader. Take the profit from the partnership accounts and:
- Add back any disallowable expenses, such as depreciation, client entertaining, and anything that does not meet the “wholly and exclusively” test for the trade.
- Deduct capital allowances, the tax-approved deduction for wear and tear on business assets.
The result is a single tax-adjusted profit figure for the whole partnership.
Step 2: Allocate the Tax-Adjusted Profit
The adjusted profit is then divided between the partners according to the profit-sharing ratio for that accounting period (ITTOIA 2005, s.850). Before the ratio applies, any prior allocations come first: partner salaries and interest on capital are deducted first, and only the remaining residual profit is split in the agreed ratio.
Step 3: Tax Each Partner as an Individual
Each partner reports their share as trading income on their personal self-assessment tax return. They each pay their own income tax and National Insurance Contributions on their share.
Basis period: The allocation is based on the accounting year. The tax year in which the profit is assessed depends on when the accounting year ends, exactly as for a sole trader.
Salary and Interest on Capital: Priority Allocations, Not Real Payments
What Is a Partner’s Salary?
Think of a busy partnership where one partner consistently works longer hours or brings in most of the clients. To compensate them before the general profit share kicks in, the partnership agreement may entitle them to a “salary”, say, £8,000 per year.
This is not a salary in the employment sense. The partner is self-employed. This “salary” is simply a mechanism for giving that partner a larger slice of profit first, before the rest is divided in the agreed ratio. It is taxed as trading income, not employment income.
A partner’s salary is not pay for work done. It is the first slice of the profit pie, reserved for one partner before anyone else gets their share.
What Is Interest on Capital?
Some partners invest more into the business than others. Their larger capital balances mean they have contributed more to the working capital of the firm. To reflect this, the agreement may entitle them to “interest on capital”, a priority allocation calculated as a percentage of their capital account balance.
Again: this is not real interest. It is a prior allocation of trading income, treated identically to a partner’s salary in the computation. The legislation governs this under ITTOIA 2005, s.850.
Computation rule: Partner salaries and interest on capital are deducted from the adjusted profit first. Only the remaining “residual” is then split in the agreed ratio. Neither is an allowable expense; they are ordered slices of the same trading income.
What About Drawings?
Partners typically take money out of the business during the year on account of their expected profit, and these are called drawings. Drawings are completely irrelevant to the tax computation. Partners pay tax on their profit share, not on what they withdraw. Drawings appear on the balance sheet but have no place in the profit allocation.
Worked Example 1: Priya, Sam, and Dev, Basic Allocation
Priya, Sam, and Dev run an engineering consultancy in partnership. Their accounts for the year ended 31 March 2024 show a profit of £160,000. The accounts include depreciation of £8,000 and client entertaining of £4,000, neither of which is allowable for tax. The tax written-down value of the main plant and machinery pool at 1 April 2023 was £50,000. They share profits 50:30:20.
Step 1: Adjust the Accounting Profit
| Item | £ | £ |
|---|---|---|
| Profit per accounts | 160,000 | |
| Add: Depreciation | 8,000 | |
| Add: Client entertaining | 4,000 | |
| Subtotal | 172,000 | |
| Less: Capital allowances (£50,000 x 18%) | (9,000) | |
| Tax-adjusted profit | 163,000 |
The 18% Writing Down Allowance (WDA) is the annual tax deduction for wear and tear on the main pool of plant and machinery.
Step 2: Allocate
| Partner | Ratio | Profit share (£) |
|---|---|---|
| Priya | 50% | 81,500 |
| Sam | 30% | 48,900 |
| Dev | 20% | 32,600 |
| Total | 100% | 163,000 |
Step 3: Tax Each Partner
Each partner reports their share on their self-assessment return as trading income for 2023/24. Priya: £81,500. Sam: £48,900. Dev: £32,600.
Worked Example 2: Nina and Oliver, Salary, Interest, and Residual Split
Nina and Oliver are in partnership. Their tax-adjusted profits for the year ended 31 March 2024 are £140,000. Under the partnership agreement: Nina receives a salary of £8,000 per year; Nina has interest on capital of £2,500; Oliver has interest on capital of £6,000. The residual profit is split 55:45 in Nina’s favour.
| Allocation | Total (£) | Nina (£) | Oliver (£) |
|---|---|---|---|
| Y/e 31 March 2024 | 140,000 | ||
| Partner salary (Nina) | (8,000) | 8,000 | |
| Interest on capital (Nina) | (2,500) | 2,500 | |
| Interest on capital (Oliver) | (6,000) | 6,000 | |
| Residual profit | 123,500 | ||
| Split 55:45 | (123,500) | 67,925 | 55,575 |
| Nil | |||
| Total profit share | 78,425 | 61,575 |
Oliver’s higher interest on capital (£6,000 vs £2,500) reflects his larger capital contribution to the business. Verification: £78,425 + £61,575 = £140,000.
Three Things to Remember
- The partnership does not pay tax. Each individual partner does, on their own share of the profit.
- Partner salaries and interest on capital are priority allocations of trading income. They are not employment income, and not real interest.
- Drawings are irrelevant to tax. Partners pay tax on their profit share, not on what they withdraw during the year.
Ready to Review Your Partnership Structure?
Whether you are setting up a new partnership, reviewing your profit-sharing agreement, or checking whether your current structure is as tax-efficient as it could be, the right advice at the right time makes a real difference.
Get in touch: Talk to a Zazentax adviser.
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