How basis period reforms will impact unincorporated UK law businesses

The UK Government?has introduced changes that affect how trading profits are allocated to tax years for unincorporated businesses, including partnerships and bodies treated as partnerships.

Known as basis period reforms, these changes and the transitional rules may bring a significant shift for law firms which are structured as partnerships, limited liability partnerships or sole traders.

At Iceberg, we are preparing to support clients to manage this significant change and help with their financing requirements.

What are basis period reforms?

Basis period reforms refer to changes in the way the tax legislation allocates profits arising from a trade or profession to a tax year for income tax income tax purposes for unincorporated businesses. It does not impact other sources of income, such as property income. Under the previous provisions unincorporated businesses were taxed on profits from the accounting period ending in that tax year. For example, a firm with an accounting year ending on 31 December 2023 would use the trading profits of that period to calculate tax for the 2023/24 tax year.

The reforms transition all businesses to a ‘tax year basis’ of reporting, where businesses will align their accounting periods with the tax year, from 6 April to 5 April, regardless of their accounting period. ???

For firms that do not currently use this tax year, adjustments will be needed to bring their accounting periods into line with the new provisions.?

When will these new rules come into effect?

The new rules have applied from the 2024/25 tax year, following a transitional period during the 2023/24 tax year.

Unincorporated businesses and the partners are now having up to submit tax returns for the 23/24 tax year transitional period.

Unincorporated businesses will be taxed on their profits for the current year (12 months to their 2023/24 accounting date), plus a catch-up period until 31 March 2024. This may result in nearly two years' profits being taxable in 2023/24 (in the case of a 30 April year end). However under the old provisions some historic profits have been taxed twice this amount is called overlap relief and is deducted from the 23/24 liability.

To alleviate the increased tax burden, the excess transitional profit can be spread over five years without interest. Alternatively, individuals can choose to accelerate this spread, taxing at least 20% annually.

With tax return deadlines and the final tax payment due on 31 January, planning ahead can help avoid any unexpected issues.

Why are these reforms being introduced?

The Government’s aim is to simplify the tax system and make it easier to understand and comply with. Under the previous system, businesses with non-tax-year accounting dates often face complex calculations and timing issues. This can be particularly challenging for partnerships, as partners must manage overlapping accounting periods and income allocations.

Additionally, the reform aligns with the UK’s Making Tax Digital (MTD) initiative, which will require businesses to submit quarterly tax updates. By standardising reporting periods, HMRC hopes to streamline digital reporting and reduce compliance burdens.

How will basis period reforms impact law firms specifically?

Legal firms, especially those structured as partnerships or sole proprietorships, will experience several impacts due to these changes:

• One-time adjustment for transitional profits: Firms with non-tax-year accounting dates will need to adjust to align with the tax year basis. The 2023/24 tax year transition period saw all profits accounted for up to the next tax year-end. For some firms, this may result in a higher taxable income in that year if profits from more than 12 months are included, leading to potential cash flow issues.
• Administrative adjustments: Firms will need to change their accounting practices to align with the tax year. For firms that prefer a different accounting year-end, this may require added administrative adjustments and could lead to increased accounting fees.
• Filing software and overlap profits: Partnerships preparing tax returns without an agent should ensure they have all necessary information and have tested their software solutions. It’s wise to run dummy returns beforehand to assess readiness. HMRC offers interactive guidance for returns and an online service to request overlap relief figures if previously provided. Firms should confirm these figures with their advisers.
• Impact on partner income and tax planning: Since many law firms operate as partnerships, the changes will directly impact individual partners’ income tax calculations. Partners accustomed to a different accounting period may need to adjust their personal financial planning and tax payments. The alignment may also affect the distribution of partnership income, potentially influencing partner earnings and forecasts.
• Working capital: It remains crucial to manage working capital effectively and ensure adequate financing with suitable contingency as we approach the tax payment date for the transitional year.

What steps should law firms take to prepare?

It’s advised that law firms should take the following steps to prepare for the basis period reforms. However, they should seek to the advice of tax specialists:

• Review accounting periods: Firms should assess their current accounting year-end and consider the implications of aligning with the tax year basis. This may involve consulting with an accountant or tax adviser to ensure compliance.
• Calculate potential impact: Work with tax advisors to project taxable income for the 2023/24 transition year, taking into account any overlap profits. This will give partners an idea of any increase in tax liability.
• Update financial plans: Adjust financial and cash flow plans to account for any potential increases in tax payments due to transitional rules. For firms anticipating a cash flow shortfall, consider financing options or spreading the additional tax liability over the five-year period offered by HMRC.
• Communicate with partners: Given that tax liabilities may shift, firms should communicate the impact of these changes to partners. Clear communication will help avoid surprises and ensure that all partners understand how their individual tax positions may change.

What are the potential long-term benefits of these reforms for law firms?

Despite the short-term challenges, basis period reforms offer potential long-term benefits.

For example, it could improve digital reporting. By moving to the tax year basis, law firms will align with MTD requirements, simplifying quarterly reporting and reducing compliance burdens over time.

Additionally, the reforms eliminate the need for complex overlap profit calculations, which can be especially beneficial when new partners join or existing partners leave. This streamlined approach reduces administrative complexities and makes income distributions more straightforward.

Finally, although the transition period may create a one-time tax impact, the ongoing alignment with the tax year should improve predictability for tax planning. With a standard tax year, firms can better manage cash flow and plan for tax payments.

This article does not constitute tax or financial advice. Legal firms should consult a professional tax expert for advice on this area.