Partnerships and LLPs paying tax earlier | Basis period reform – what does it mean for law firms?

In 2023, HM Revenue and Customs (HMRC) announced the implementation of reforms to the basis period method for taxation, which applies to unincorporated businesses and limited liability partnerships (LLPs), with effect from 6 April 2023.

These changes come with significant cash-flow implications and affect all sole traders, unincorporated partnerships and LLPs that currently do not prepare their annual accounts to a reference date ending between 31 March and 5 April.

New basis period rules

The new legislation has changed the way in which trading income is allocated across tax years. It means that, from the start of the 2024/25 tax year on 6 April 2024, the basis periods of all partnerships and LLPs will be aligned to the tax year, irrespective of when the firm’s accounting reference date falls.

In order to transition to the new regime, HMRC has implemented various rules. The following key points apply:

• The ‘standard’ part – the normal accounting period; plus
• The ‘transition’ part – from the end of the ‘standard’ part to 5 April 2024; less
• Overlap profits brought forward – this is the portion of profits taxed twice in these tax years. It has to be offset and there is no option to carry these forwards
• Transitional profits – the ‘transition’ part less overlap, can be spread equally over five years starting with 2023/24 and finishing with 2027/28
• An election can be made to accelerate all or part of these transition profits – each partner can make their own decision

The 2023/24 transition year

The 23/24 tax year (to 5 April 2024) was a transition year, for which the basis period was 12 months from the end of the firm’s basis period for 2022/23, plus the additional time to 5 April 2024 following the end of such period.

Relief will be given for any overlap profits generated under the current basis period rules.

Example

The changes mean that, for example, a firm which had a 30 April 2022 year-end (which would mean its profits fell to be taxed in the 22/23 tax year) would have a basis period running from 30 April 2022 to 5 April 2024.  The firm will be required to apportion profits from the two different accounting periods to produce a profits figure on the tax year basis, and initially file tax returns based on provisional figures, with amendments to be made in re-filed returns the following year.

This will result in the firm’s partners being taxed on nearly two years’ profits rather than one by way of a ‘catch-up’ to the new tax-year aligned basis period.

Year-end 30 September 2023	£100,000
Period 1: October 2023 to 31 March 2024	£50,000
Total	£150,000
Less: overlap profits brought forward	(£30,000)
Taxable profits	£120,000

Under the current rules, the taxable profits for the 2023/24 tax year would be £100,000 but the changes see taxable profits of £130,000 for 2023/24.

The excess profits of £20,000 can therefore be spread across five tax years, with an additional £4,000 taxable over the five years from 2023/24 to 2027/28.

Why are these changes taking place?

The aim is to simplify individuals tax affairs and the rules for allocating of trading income to particular tax years and removing the current requirements relating to double taxation of early years of trading profits.

The changes will also accelerate the speed with which income tax needs to be paid over to HMRC, therefore bringing the payment of tax closer to the point at which profits are earned.

 What do law firms need to consider?

Eventualities such as partners electing not to spread the profits in the transition year should be taken into account, alongside any future changes to tax rates.

A key consideration for the firm will be its capital position, in addition to the spreading across future tax years under the reforms.

Craig Reid, Sales Director at ShirePF, commented: “The basis period reform forces firms to estimate the cash-flow impact of the accelerated tax liability and find ways to mitigate any undesired scenarios. The changes are yet another challenge that legal practices and professionals are facing, which is outside their control. As a broker and lender working with solicitors on a daily basis, client feedback indicates that over the past few years many of the key outlays for law firms, such as professional indemnity insurance, VAT, and more, have risen. Tax seems to be the next ‘target’ and the reforms have made it yet another crucial thing to consider.

All of these add more pressure on working capital. Using third-party loan facilities, where possible, is the easiest way of avoiding any potential cash-flow issues.  As the strategic partner to the Law Society of England & Wales for finance, we can help those legal practices and professionals in need with our simple tax funding solution, tailored to their individual circumstances.”

You can learn more about our tax spread payment loan facility here.