Unlike recent fiscal events, this Autumn Statement largely focused on those on lower incomes, with an absence of measures specifically aimed at higher and additional rate…
What is ‘basis period change’?
Currently, self employed partners in law firm partnerships pay income tax on their share of profits for the accounting period ending in the tax year of assessment – this is known as the current year basis. So, if you have a 30 April year end, for the tax year 2022/23 (ending 5 April 2023), a partner will be assessed on profits from the financial year ended 30 April 2022.
The change will see all partners being taxed on the profits in the actual year they have been accrued – known as a tax year basis.
The change to a tax year basis will happen from 6 April 2024, and partners will be taxed on the profits from the actual year to 5 April 2025. The 2023/24 tax year, starting on 6 April 2023 will be known as a transitional year and will be subject to special rules.
The key point here is that this is an acceleration of income tax payments and not an additional income tax charge. However, the cash flow ramifications for many law firms will be significant and will impact on the funding of their business over the next five years.
It should be noted that if a law firm’s financial year end is 31 March or between 31 March and 5 April, then none of these basis period changes with affect partners in those law firms.
How will my profits during the transitional year (2023/24) be calculated?
For each partner, all taxable profits from the end of the accounting period that formed the basis for the 2022/23 assessment, up to 5 April 2024, will be assessed in 2023/24. In the worst case scenario, if the partnership has a 30 April year end this will mean that 23 months’ profits will potentially be assessed in one go (subject to overlap relief brought forward and spreading).
Partners retiring in 2023/24
If a partner retires in 2023/24, the old rules (current year basis) will continue to apply until they leave the partnership.
How does spreading work?
Spreading is only available for the transition profits, which are the profits where the tax payments are being accelerated for them (for a 30 April year end that means from 1 May 2023 – 5 April 2024). Where there are transition profits for that tax year, the profits will automatically be spread and taxed on the partner (equally) over five years.
If a partner leaves the partnership at any point before the start of the fifth year, the balance of the transition profits is treated as arising in the tax year of them leaving. This happens regardless of the reason for leaving the partnership.
Electing to opt out of spreading
For tax purposes, in a law firm partnership, each partner is treated as carrying their own notional business, so each partner can make their own decisions on spreading. Whilst spreading applies automatically, it is possible for an individual partner to elect to accelerate any element of their remaining untaxed transition profits.
If a partner does make an election, the remaining untaxed transition profits will be spread evenly over the remaining tax years.
Why would a partner elect to opt out of spreading?
A partner may choose to do this if, for example, they have a year when their taxable income is lower than normal and they have capacity to use up their 40% tax band resulting in lower charges in future years when higher tax rates are likely to apply.
An election must be made by a partner on, or before, the first anniversary of the normal self-assessment filing date for the tax year to which it relates. So, for example, for 2024/25 (tax year 5 April 2025), the election must be made by 31 January 2027.
The election must state the amount of the transition profits that the partner wants treated as arising in the relevant tax year.
Practical and commercial issues arising from spreading rules for the law firm
It is important to note for law firm partnerships that deciding whether or not to opt out of spreading is a partner’s personal tax planning decision, and not the firm’s decision. It is therefore likely that many partners will take different approaches.
Key points to consider:
- Tax provisions and reserves – with different partners taking different approaches this could make calculating tax provisions and reserves for the firm more complicated
- Cash flow – if lots of partners opt out of spreading this could create a more significant cash requirement for the firm, so it is important to manage this uncertainty
- Capital funding and the debt needs – if lots of partners opt out of spreading this could also impact the longer term funding of the firm
- Joining partners – will have more complicated tax provisioning considerations if they are already subject to spreading
Whilst brought forward overlap profits will be available to relieve against transition profits, partners will want to be satisfied that their firms hold sufficient reserves to cover the accelerated tax payments.
It will be imperative that partners keep their practice managers (and accountants) up to date with their decisions as early as possible, to ensure that the proper provisions and the appropriate tax elections can be made.
Pensions and Class IV national insurance contributions (NIC)
Transition profits taxable in a specific tax year do count towards relevant earnings for pension contributions and will also be chargeable for Class IV national insurance in the normal way.
However, these spread profits will not be included adjusted income for the purpose of calculating the pension annual allowance. This could give partners some planning opportunities, as they may be able to make higher pension contributions without hitting their annual allowance limit, particularly since the recent abolition of the life time allowance (currently at £1,073,100).
What about overlap profits?
All overlap relief brought forward will need to be used up in 2023/24, and in future no overlap will accrue because each partner will be taxed on profits allocated to them between 6 April and 5 April.
Partners will need to know how much overlap profit they have. This figure should be included on the partner’s annual tax return each year, however, this may not have been calculated when the overlap profits first arose, or it may have been omitted from returns after they arose.
HMRC is looking at ways of providing overlap relief figures direct to taxpayers and their tax advisors and they have confirmed that requests will be handled by a dedicated team in HMRC. An on-line form is being developed and they recommend that everyone uses the online process once it is available because it will be quicker than postal or telephone requests.
Should law firms change their partnership year-end?
The answer to this is probably ‘no’ but it will depend on the individual law firm.
If the firm has a year end other than between 31 March and 5 April, then the changes remove the immediate link between the firm’s accounting period and the individual partner’s basis periods. In these circumstances firms may wonder if a change to 31 March year end would be of benefit to them.
Points to consider:
- There is no tax saving or benefit to changing the financial year end of a partnership
- A firm can change their year end at any time – you do not have to make a decision now
- Changing financial year ends can have unforeseen consequences – for example profits get reported in different periods or fee earners behave differently on billing
- Changing year end brings a degree of internal complication and when comparing financial performance for a subsequent period
- Providing the existing financial year for the law firm is on, or before 30 September, it is highly unlikely that any estimated profits will need to be used in tax returns under the new basis periods
For those with accounting periods after 30 September it does become more likely that the firm will need to estimate taxable profits on tax returns and this can have the disadvantage of extending the enquiry period for HMRC on personal tax returns where reported profits will need to be finalised once known. It therefore may be beneficial for those with later year ends to make a year end change to give them a longer period to assess their taxable profits, before they need to be reported to HMRC.
If a firm does decide to change, then it would need to be made during the 2023/24 tax year (5 April 2024) at the earliest. If the change is made before that date, partners will not qualify for spreading and all of the transition profits would be subject to income tax in that tax year.
What happens if a law firm retains a late year end and provision figures are required for tax purposes?
If, for example, a firm retains a December year end, it is probable that for each January, when partners need to submit their tax returns, that they would have to do so with some provisional profit pending the finalisation of accounts of the firm which ended only one month prior to the submission date. The return would need to be re-filed once the final figures are known.
HMRC recognises that this is problematic and has therefore said that it will remove the current requirement to amend estimated figures ‘without delay’ and allow the amendment to be filed when the following year’s tax return is filed (i.e. within the normal time limit for filing amendments).
HMRC has been silent on enquiry periods, but it is expected that the normal rules where a return is submitted late or is amended by the taxpayer will apply – the deadline for returns to become final is the quarter day that follows the first anniversary of the date of submission or amendment. So, the return for 2025/26 (due for submission by 31 January 2027), which is amended on 31 January 2028, will not become final until 30 April 2029, instead of 31 January 2028 as it would have done without amendment.
Key points to consider for law firm partnerships
- Managing cash outflow – what is the cash outflow impact on business funding?
- Strategic decisions for replacing long term funding from tax reserves:
- Review of debt and equity in the partnership
- Renegotiating funding with banks or debt providers
- Capital funding planning for the future and projected partner capital levels
- Strategies to reduce lock up
- Consider whether a change of financial year end is necessary
- Consider the impact of individual partner spreading decisions
- Review the practical impact on future tax provisioning for the firm
Key points to consider for partners in a law firm partnership
- Estimate your personal transitional profits
- What is the outlook for your taxable earnings during the spreading period?
- Think about pension planning options in conjunction with spreading elections
- Consider the impact of potential additional partner capital account requests
- What could the impact be of potential delays in future partner current account pay outs?
At PKF Francis Clark, our legal sector team are assisting a wide range of law firm partnerships and their partners with the commercial, funding and tax planning issues arising from the basis period changes. If you would like further information on the above issues, please do get in touch with us.