For tax, a partnership’s adjusted profit is divided between the partners according to the profit sharing arrangements in force for the accounting period, including any salaries, interest on capital and the residual ratio. Salaries and interest on capital paid to partners are shares of profit, not deductible expenses. If the sharing formula would give one partner a notional loss while the firm makes a profit (or the reverse), sections 850A and 850B of ITTOIA 2005 reallocate the actual result so that no partner is taxed on a profit or relieved for a loss the firm never made.

What decides each partner’s taxable share?

Section 850 of the Income Tax (Trading and Other Income) Act 2005 (ITTOIA) says a partner’s share of a trading profit or loss for a period of account is determined by the firm’s “profit sharing arrangements” during that period, meaning the partners’ rights to share in profits and liabilities to share in losses. HMRC’s Partnership Manual sets out the order of work (PM163070): start with the accounting profit, adjust it for tax, then allocate the adjusted figure using the sharing arrangements for that accounting period. Where any partner pays income tax, section 849 requires the profit to be calculated as if the firm were a UK resident individual. Capital allowances are claimed by the firm, so partners share profit after allowances (PM163010).

If there is no written agreement, section 24 of the Partnership Act 1890 sets the default rules: partners share equally in capital and profits, are not entitled to interest on capital before profits are ascertained, and are not entitled to remuneration for acting in the business. Many firms only discover they are on these default terms when a dispute arises. LLPs have their own default rules; see limited liability partnerships.

The allocation shown in the partnership return is conclusive for tax under section 12ABZB of the Taxes Management Act 1970, unless a tribunal decides otherwise on a referral. Each partner is taxed on the share allocated to them, whether or not they have drawn it in cash.

Are partners’ salaries and interest on capital tax deductible?

No. HMRC’s Business Income Manual (BIM45735) says interest on partners’ capital accounts must be disallowed because it is an allocation or distribution of profit to a proprietor. The same applies to a partner’s “salary”: in HMRC’s own SA800 guidance, a salary is simply the first slice of the allocation, with the balance shared in the agreed ratio. PM163330 adds that amounts paid to partners are part of the divisible profit unless shown to be wholly and exclusively for the business, so a firm paying a partner’s personal bills is distributing profit, not incurring an expense (see the wholly and exclusively rule).

There is one distinction worth knowing. If a partner lends money to the firm, as opposed to contributing capital, the interest is an allowable expense of the firm and is taxed on the partner as interest income (BIM45735). Interest a partner pays personally on a loan used to buy into the firm or provide it with capital is not a partnership expense; it may qualify for qualifying loan interest relief under sections 398 to 400 of the Income Tax Act 2007 (SAIM10280).

How is profit allocated when there are salaries, interest and a ratio?

Work through the agreement in the order it sets out. Usually that means salaries first, then interest on capital, then the residue in the profit sharing ratio.

Illustration only. Asha and Ben share residual profits 60:40. Asha is entitled to a salary of £20,000. Both receive 5% interest on capital: Asha has £40,000 of capital and Ben £20,000. The tax adjusted profit is £120,000.

Asha Ben Total
Salary £20,000 nil £20,000
Interest on capital at 5% £2,000 £1,000 £3,000
Residue £97,000 at 60:40 £58,200 £38,800 £97,000
Taxable share £80,200 £39,800 £120,000

Asha’s £80,200 goes in her column of the partnership statement, and because the split is not a simple percentage, the salary and interest terms are explained in box 3.116 of the return, as HMRC’s SA800 guide requires. The full filing process is covered in partnership tax returns (SA800).

What happens if the formula gives someone a notional loss?

When salaries or interest exceed the profit, the formula can allocate more than the actual profit to some partners and a “notional” loss to others. Section 850A stops this. A partner whose share would be a loss in a profitable period is treated as having neither a profit nor a loss, and the actual profit is shared among the profit making partners in proportion to their notional profits. HMRC’s guidance (PM163050) puts it this way: the allocation must not create or increase a loss.

HMRC’s own example at PM163060: Alan, Beatrice and Cassandra make a profit of £8,900. Alan and Beatrice each have a salary of £5,200 and the balance is shared equally. The formula gives Alan and Beatrice £4,700 each (£5,200 less a third of the £1,500 shortfall) and Cassandra a notional loss of £500. Because £9,400 of notional profit has been allocated against an actual profit of £8,900, the £8,900 is reallocated in the ratio 4,700:4,700. Alan and Beatrice are each taxed on £4,450; Cassandra is allocated nothing and has no loss to claim.

The rule is not just arithmetic. In PDC Copyprint v George (1997), cited at PM163050, the Special Commissioners held that partners could not inflate loss claims by paying a salary to one of their number.

How are losses shared in a loss making year?

Section 850B mirrors the rule for losses. If the firm makes a loss but the formula gives a partner a profit, that partner’s share is nil and the actual loss is spread among the loss making partners in proportion to their notional losses. In HMRC’s example 3 at PM163060, a loss of £1,600 with a £4,400 salary for Alan and residual sharing of 25:25:50 initially gives Alan a profit of £2,900 and Beatrice and Cassandra notional losses of £1,500 and £3,000. After reallocation Alan is allocated nil, Beatrice a loss of £533 and Cassandra a loss of £1,067. Loss relief is then claimed by each partner on their own return.

What if the ratio changes, or partners are taxed differently?

Because section 850 looks at the arrangements “during that period”, a change of ratio part way through an accounting period has to be reflected in the allocation for that period. HMRC’s SA800 guide says the allocation should be made to the people who were partners during the accounting period for which the profit is returned. Each separate trade needs its own allocation, and other income, such as interest, is normally shared in the same ratio as the residual trading profit.

Where the partners include a company or a non resident, extra computations are needed: corporate partners’ shares are computed under Corporation Tax rules and non residents’ shares as if the firm were non resident (PM163030). Allocating a large share to a company partner owned by an individual partner can trigger the mixed membership rules in section 850C, which move profit back to the individual. In an LLP, fixed profit shares can also make a member a salaried member, taxed as an employee.

What mistakes do partnerships make with profit sharing?

  • Deducting partners’ salaries or interest on capital in the tax computation as if they were wages or finance costs.
  • Claiming loss relief for a notional loss created by a salary when the firm actually made a profit.
  • Leaving box 3.116 blank when the split is not a simple percentage, which makes HMRC’s checks harder and invites questions.
  • Using this year’s ratio for an accounting period that was governed by last year’s agreement.
  • Treating drawings as the taxable figure. Tax follows the allocation on the partnership statement, not the cash taken out.
  • Relying on an unwritten understanding that differs from the Partnership Act default of equal shares.

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Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 8 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.