Class 4 NI refunds for sleeping partners

A “sleeping partner” is a partner who does not take any part in the running of the partnership’s business. HMRC now accepts that such a partner is not liable to Class 4 NIC, because they do not fall within the definition above. Class 4 National Insurance contributions are paid as a percentage of your annual taxable profits - 9 per cent on profits between £7,225 and £42,475, and a further 2 per cent on profits over that amount.

In the past, there has been a reluctance to classify a partner as a “sleeping partner”, particularly in the case of the standard husband and wife partnership. This was because there was a fear that HMRC would argue that the sleeping partner was not really entitled to their profit share, and that as a result the active partner had made a “settlement” on the sleeping partner by consenting to their having a share of profits they had not “earned”. The fear was that HMRC would therefore seek to tax the active partner on the profits diverted to the sleeping partner – often with the result that those profits would be liable to income tax at 40% instead of the 20% they suffered in the hands of the sleeping partner.

In 2007 however, a tax case known as the “Arctic Systems” case went to the House of Lords, and the taxpayer won. In that case, a husband and wife had set up a limited company which received Mr Jones’ (the husband's) earnings as a software engineer, and paid them out in dividends to Mr Jones and to his wife. HMRC tried to argue that because Mr Jones had effectively given his wife the opportunity to enjoy the dividends from the company, he should pay tax (at 40%) on all of them. HMRC lost, and in their judgement, the Lords made it clear that the same argument would apply to a sleeping partner – each partner was taxable on their share of the profits, and HMRC could not tax the active partner on the profits of the sleeping partner.

This means that in a case where one of the partners does not actually get involved in running the business, that partner is not liable to Class 4 NIC. If they have in fact been paying Class 4 NIC in the past the could also be eligible for “error or mistake” relief and get it back.

Update - April 2013: HMRC has changed its view on the NICs liability of sleeping and inactive limited partners. It now considers that they are liable for Class 2 & 4 NICs. You can find the reasoning behind that change of mind at http://www.hmrc.gov.uk/news/sps-lps-announce.pdf.