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Could you have an large tax bill on retirement?

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I am planning to retire from my partnership on 31st March 2006. Our partnership prepares the accounts to 30th June each year and I have heard something about overlap profits, which may mean I will have a large tax bill after I leave. I am unsure how this will affect me?

If you have an accounting year end which does not coincide with the tax year, then depending on when you retire from the partnership this could result in a large tax bill, this is due to the way profits are taxed in the year you retire.

As your partnership prepares accounts to 30th June, in the tax year 2005/06 you will be taxed on your share of profits for the year ended 30th June 2005 and your share of profits from 1st July 2005 to 31st March 2006 i.e. you will pay tax on 21 months of profits in 2005/06.

The tax rules state that you can not be taxed on more than twelve months’ profits in one tax year. To reduce your profits from 21 months to 12 months you would deduct your overlap profits, which would be equivalent to 9 months profits. (see Table A). However, the problem with overlap profits is that they are likely to be based on profits from earlier years, which would be much lower than the profits you will earn in 2005/06.

Overlap profits either arose in 1996/97 when self-assessment was introduced or on joining a partnership. These are profits that have been taxed twice and therefore are deducted on leaving a partnership or change of accounting year end.

Your accounts for the year ended 30th June 2005 have already been prepared, so we can estimate your potential tax liability which would become payable in January 2007 (see Table A)

The accounts for the year ended 30th June 2005 show your individual profits of £139,000. It is estimated that your share of profits from 1st July 2005 to 31st March 2006 will be in the region of £120,000. This gives total profits for 21 months of £259,000. Your overlap profits are £40,000, this is equivalent to nine months profits earned in 1996/97.

After your £40,000 deduction of overlap profits, your taxable profits in 2005/06 will be £219,000 this represents profits for 12 months. However, the problem is that your nine months profits from 1st July 2005 to 31st March 2006 are estimated to be £120,000 compared to the equivalent nine months overlap profits of £40,000 which arose in 1996/97, this means you have tax to pay on the additional £80,000 in 2005/06.

As a result you would have a potential balance of tax for 2005/06 of £38,000 due in January 2007.. On this date you would also be required to make a payment on account for the next tax year, 2006/07 of £42,000 giving a total tax payment due by 31st January 2007 of £80,000.

However, if you are only going to be receiving your pension in 2006/07, your accountant can apply to reduce your payments on account for 2006/07, as these are based on your earning self employed income of £219,000.

Table A

  Tax year 2005/06 Equivalent no of months
Profits – ye 30.06.05
Profits – to 313.03.06
Total
Overlap profits
Taxable Profits

Total tax due on profits
1st Payment on a/c 2005/06
2nd Payment on a/c 2005/06
Balance 2005/06 due January 2007
139,000
120,000
259,000
(40,000)
219,000

84,000
(23,000)
(23,000)
38,000
12 months
9 months
21 months
(9 months)
12 months

 

With the introduction of the new GMS contract, practices are already seeing large increases in profits, which are expected to continue in 2005/06. GPs planning to retire whose accounting year end does not coincide with the tax year, should ensure they seek advice from their accountant as to their potential tax liabilities. If GPs are unaware of the rules regarding the final taxation of profits, a large tax bill may come as a nasty shock, especially if they are only receiving a pension.

GPs could consider going part time before they retire so that their final profits on retirement from the partnership would be reduced and after deduction of overlap profits may not leave a large amount of profits to be taxed.

A final thought, for GPs considering retiring, is that it may be advisable to wait until after 31st March 2006, to gain the maximum pension benefit under the new contract.

August 2005