Partnership Tax

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A partnership, unlike a company, is not technically a separate legal entity but rather describes a relationship between partners. There are two common categories of partnerships from a taxation perspective. Firstly, a general law partnership which is a partnership through which a business is conducted. Secondly, a tax law partnership which does not involve carrying on a business but generally describes persons in receipt of income jointly from jointly owned assets.

For example, a rental property owned jointly by spouses is a form of tax law partnership. A partnership also encompasses a limited partnership but specifically does not include a joint venture arrangement. Limited partnerships and joint ventures are taxed differently to general law and tax law partnerships. These are not addressed in this article.

The partners of a partnership are the persons taxed on taxable income or ‘net income’ which is produced within the partnership. The partnership itself is not taxed. However, it is necessary that the net income of the partnership is calculated and an annual partnership tax return is lodged (as if the partnership were a stand-alone entity).

The net income of the partnership is calculated according to Division 5 of the Income Tax Assessment Act 1936 as follows:

assessable income less allowable deduction as if the partnership were an Australian taxation resident (with exceptions). Once the net income (or loss) of the partnership is calculated, an allocation of the net income to partners occurs. Essentially, each partner will include in their assessable income, ‘…so much of the individual interest of the partner in the net income of the partnership of the year of income…’. (Section 92 of the Income Tax Assessment Act 1936).

Note that accounting profit and the partnership agreement considered together determine each partner’s percentage ‘interest’ the partnership profits. The partnership net income or loss is then, on a proportionate basis (similar to trusts) allocated to partners according to each percentage interest.

Therefore, the following steps should be followed each year to determine the tax position of each partner in the partnership:

  • Calculate partnership accounting profit or loss for the income year.
  • Calculate partnership net income or loss for the income year.
  • Calculate each partner’s percentage entitlement to accounting profit or accounting loss.
  • Calculate each partner’s assessable income / tax deduction.

These steps are discussed in further detail below.

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Step 1: Calculate partnership accounting profit or loss for the income year

In some instances, there will be no difference between accounting profit / loss and net income / loss. However, there are technical differences between the two concepts and you should understand when variances can arise. Generally, a qualified accountant would assist to prepare the partnership financial statements and determine the accounting profit or loss.

Step 2: Calculate partnership net income or loss for the income year

The net income of the partnership is calculated according to Division 5 of the Income Tax Assessment Act 1936 as follows:

Assessable income less allowable deduction as if the partnership were an Australian taxation resident (with exceptions).

Note that partnership assessable income does not include capital gains. These are taxed exclusively in the hands of each partner based on fractional ownership interest in the underlying CGT asset. Also note the following items which are not deductible against partnership net income:

  • personal superannuation contributions (may be deductible to partner in their own tax return)
  • drawings
  • interest paid on capital
  • salaries to partners
  • prior year losses (may be utilised by the partner in their own tax return).

Salaries to partners

A partner salary is treated as a profit allocation prior to the general division among the partners – hence it is not deductible.

Derivation of income

Income is assessable income when it is ‘derived’. In respect of partnerships, this occurs at the point in time when the partnership itself derives the income, not when partners themselves receive the income.

Prior year losses

Any tax loss allocated to partners may be deductible for the partner personally. For example, assume there is a married couple which jointly owns an investment property 50/50. The property is negatively geared and produces an annual tax loss of $10,000. Each partner may include their proportion of the loss, being $5,000 (50% of $10,000) as a deduction against their other assessable income e.g. their salary.

Step 3: Calculate each partner’s percentage entitlement to accounting profit or loss

The partners of the partnership are generally entitled to share profits (or required to bear losses) in accordance with the terms of the relevant partnership agreement. Therefore, refer to the partnership agreement in the first instance to determine each partner’s percentage entitlement to profits or losses.

Note that joint owners under a tax law partnership are not permitted to determine a partner’s entitlement to accounting profit by agreement. Each partner’s percentage entitlement is determined by percentage ownership interest in the underlying assets.

For example, a rental property owned by a married couple 50/50 with an accounting profit and net income of $10,000 for financial year 2023 must be split such that each spouse is assessed on half of the net income, being $5,000 each.

Note that where the property investment activity by the spouses / partners was sufficiently ‘business-like’, the activity may in fact constitute a ‘business’ of investment. In this instance, a general law partnership would exist and the entitlement of each partner could be manipulated by terms of a partnership agreement.

There are a number of factors to be considered in determining whether a business is carried on in a partnership. These factors are set out and considered in Taxation Ruling 94/8. Generally, the higher the degree of active involvement and business-like behaviour, the more likely there will be a business.

In this instance, to carry on with the example above, the married couple could agree by partnership agreement that the first spouse should receive all profits. The first spouse would therefore be assessed on 100% of accounting profit i.e. $10,000. There are obvious tax planning opportunities related to general law partnerships which are not available to partners in a tax law partnership.

Step 4: Calculate each partner’s assessable income / tax deduction

For each partner, multiply the percentage entitlement of each partner calculated at step 3 by the net income of the partnership calculated at step 2.

Worked example incorporating steps 1 – 4:

Partner A and Partner B run a business through a partnership. At the end of the financial year, the accountant determines the partnership accounting profit is $100,000 and determines partnership net income is $60,000.

In this instance, the reason there is a difference between accounting profit and net income is because the partnership was permitted under tax law to write-off certain assets in the year of purchase.

For accounting purposes, the asset could only be ‘expensed’ or ‘depreciated’ over a period of 10-years, being its useful life. This created a mismatch between accounting profit and taxable income (a common occurrence in practice). The partnership agreement provides that Partner A is entitled to the first $70,000 of partnership profits and the remainder is allocated to Partner B.

Step 1: Calculate partnership accounting profit or loss for the income year
$100,000.

Step 2: Calculate partnership net income or loss for the income year
$60,000.

Step 3: Calculate each partner’s percentage entitlement to accounting profit or loss
Based on the terms of the partnership agreement, Partner A is entitled to the first $70,000 of partnership profits. Here, partnership profit is $100,000. Therefore, Partner A has a percentage entitlement to profits of 70% ($70,000 / $100,000). Partner B is entitled to the remaining profit of $30,000 and therefore has a percentage entitlement of 30% ($30,000 / $100,000).

Step 4: Calculate each partner’s assessable income / tax deduction
The percentage entitlement of each partner calculated at step 3 is used to calculate their share of net income of the partnership. Here, Partner A will include in their personal tax return as assessable income $42,000 (70% share of partnership profit x $60,000 net income). Partner B will include in their personal tax return as assessable income $18,000 (30% share of partnership profit x $60,000 net income).

A man and a woman shaking hands in a corporate office, representing the concept of partnership tax.

Partnership salary

As mentioned, a partner salary is considered to be a profit allocation and is not deductible. The payment of the salary to a partner will vary the recipient partner’s interest in the partnership profit (and therefore the partner’s interest in the net income of the partnership).

An example of the implications of a partner salary is shown below.

Example
There is a business run through a two-person general law partnership involving partner A and partner B. The accounting profit for the financial year is calculated as $100,000. The partnership net income is calculated as $150,000. Pursuant to terms of the partnership agreement, partner A is paid a salary of $50,000 and the remaining profit is split 50/50 between the two partners.

Step 1: Calculate partnership accounting profit or loss for the income year
As above, $100,000.

Step 2: Calculate partnership net income or loss for the income year
As above, $150,000.

Step 3: Calculate each partner’s percentage entitlement to accounting profit or loss
For Partner A, interest in partnership accounting profit = 75%.

That is, $50,000 salary + (50% equal share to residual post-salary profits x ($100,000 partnership accounting profit – $50,000 salary)) = $75,000. Percentage entitlement: $75,000 share of partnership profit / $100,000 partnership accounting profit = 75%.

For Partner B, interest in partnership accounting profit = 25%.

That is, 50% equal share to residual post-salary profits x ($100,000 partnership accounting profit – $50,000 Partner A salary) = $25,000. Percentage entitlement: $25,000 share of partnership profit / $100,000 partnership accounting profit = 25%.

Step 4: Calculate each partner’s assessable income / tax deduction
For Partner A, assessable income: $112,500.

That is, 75% partnership interest percentage x ($150,000 net income of partnership / $100,000 accounting profit).

For Partner B, assessable income: $37,500.

That is, 25% partnership interest percentage x ($150,000 net income of partnership / $100,000 accounting profit).

Note that where the partner salary exceeds the partnership accounting profits, the surplus will apply against accounting profits in future income years and in so doing will vary the partnership interests (in the same manner as above) in those future income years.

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Variation of partnership interests

A variation of interests in a partnership can occur where a partner retires or becomes deceased or where a new partner joins the partnership. The variation will generally have the technical impact of causing the partnership to cease and a new partnership to commence.

This regularly presents a tax problem for partnerships as the cessation and creation of a partnership is a trigger point for various taxation events. In these instances, assets of the partnership are deemed to have been disposed by the old partnership and acquired by the new partnership.

Specific tax consequences can include

  • capital gains tax (at the partner level).
  • assessable amounts from balancing adjustments in relation to depreciable assets.
  • trading stock notional disposal.
  • the requirement to prepare two (or more) tax returns for the year. This includes a return for
  • the old partnership and a separate return for the new partnership.

There are various concessions which may be available to avoid these often undesirable tax consequences.

For example, the partners could consider:

  • Including a partnership continuity clause in a partnership agreement that provides that continuing partners are permitted to carry on the business with no need to take accounts. If this occurs, the ATO will treat the partnership as a reconstituted partnership. Only one partnership tax return will need to be lodged.
  • Taking steps to best ensure previous partners maintain an ownership interest of at least 25% in trading stock. A trading stock election can be made that prevents the trading stock from otherwise being deemed ‘disposed’ for market value.
  • Taking steps to best ensure that certain partners continue to hold at least a part interest in depreciable assets before and after variation. An election can be made such that disposal proceeds of a depreciating asset are deemed to be current written-down value. The implication being that no assessable balancing adjustment is required.

This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.