CAPO Digital Accounting looks at ways of reducing income tax on business income by spreading it amongst the family and others.
It is a common problem that the UK taxes families where there is only a single earner more heavily than where there are multiple earners.
A straightforward example of household income of £100,000 illustrates this. If there is a single earner, perhaps someone carrying on a business, who makes profits of £100,000, roughly half of this will bear income tax at 40%, whereas two earners making profits of £50,000 each will enjoy the basic rate of tax on all that income.
For this reason, it is common for people in business to look at ways of spreading the income from a business amongst more than one person. There are various ways of doing this, straightforward or not so straightforward, depending on how the business is structured.
Become a partnership?
Probably the most straightforward example of spreading the income is taking another family member into partnership, as in the following example.
Example 1: Husband and wife partnership
Wendy runs a successful business manufacturing ladies’ clothes, and the profits on this are £100,000 and upwards per annum.
Her husband, George, has no income of his own and for many years, Wendy has had him on the payroll, paying him £12,000 a year. This goes some way towards spreading the income between the two family members, but not very far. So Wendy decides, on the advice of her accountant, to bring George into partnership, splitting the profits 50:50.
In broad terms, the tax saving is the extra £38,000 of the income, which will be bearing tax at 20% rather than 40%: an annual income tax saving of just under £8,000 (although the self-employed National Insurance contributions implications also have to be considered).
This example illustrates another way in which business people often seek to use the personal allowances and, sometimes, lower rate bands of other family members by paying them a wage. And there’s a crucial difference between the two ways of doing it. The payment of wages, although popular, depends for its effectiveness as tax planning on the person receiving the wages doing a job of work in return. HMRC can and does seek to disallow such ‘family wages’ where the person concerned would not be paid that much for their services if they were not in some kind of relationship with the person making the payments.
By contrast, a partner’s profit share does not depend on services being provided by the partner. So in the very simplest of situations, you effectively have a trade-off between the greater flexibility of what you can pay a partner on the one hand, against the administrative hassle of bringing someone into partnership on the other. As well as this administrative hassle (e.g., notifying HMRC for VAT purposes if the business is VAT registered, and notifying the self-assessment department of the existence of a new self-assessment taxpayer), there’s also the fact that the new partner will, of course, be jointly and severally liable for all the debts of the partnership. In some (but not all) kinds of business, this might be a significant disincentive to the family members concerned to becoming partners because they may be in the position of having no control over what debts and other liabilities the business incurs.
In cases where this is a serious concern, but the business is not to be converted to a limited company for any reason, the limited liability partnership (LLP) may well be the answer. As the name implies, this is a vehicle which provides limited liability to its members but is taxed in the same way as a partnership.
Income spreading in limited companies
But there may be reasons, unlinked to the subject of this article, why the business may be set up as a limited company rather than in unincorporated form (sole trader or partnership).
There are a number of tax reasons, including the fact that companies pay a lower rate of tax (currently 19%, with a top rate of 25% coming in next year). Where a business retains an amount of its profits, it can be highly advantageous to have those profits retained after only corporation tax rather than after paying income tax plus National Insurance contributions at combined rates totalling a maximum of 47%.
Again, of course, the straightforward method of spreading income is to take on the family members concerned as employees being paid a wage. But the same constraints about the value of their services and possible disallowance of those wages by HMRC clearly apply.
The equivalent in the limited company sphere to bringing someone into partnership is to issue them with shares in the company.
Example 2: Shares issued to sons
Paul and Paula own 51% and 49% of the issued ordinary shares of Epistle Limited. Their children are Timothy, 18, and Barnabas, 16.
On their accountant’s advice, Paul and Paula pass a resolution for 20 ‘A’ ordinary shares to be issued: 10 each to Timothy and Barnabas. These shares rank ‘pari passu’ with the ordinary shares but only constitute one-sixth of the expanded share capital of the company, and therefore in normal circumstances will not interfere with the parents’ control over the company.
Dividends are then paid on the ‘A’ shares.
This example brings out one or two important points about the issue of shares in a company for income spreading purposes. Firstly, issuing shares of a different class enables dividends to be paid at a different rate on the other family members’ shares from the main shareholder or shareholders. This can be a vitally important bit of flexibility where the main purpose of the issue of the new shares is in order to utilise family members’ personal allowances or basic rate bands, but not necessarily pay the full rate of dividends that the profits of the company overall would suggest to be appropriate.
Secondly, many readers will have spotted the problem, in tax planning terms, with what Paul and Paula have done in this instance. This is that shares had been issued to Barnabas, who is under 18. Dividends paid on these shares will be taxed on the parents under the ‘Settlements on minors’ rules. However, once another couple of years have passed and Barnabas has reached the age of majority, dividends paid will be taxed on him after all.
Thirdly, a problem arises in some cases of income spreading which does not arise in the above example. Where shares are issued to a person by reason of their employment with a company, the issue of the shares itself can comprise taxable income, so great care should be taken where it is proposed to bring in people who are, or who are to become, employees of the company, except in cases where it is clear that the shares are being issued to the new shareholders because they are members of the family rather than because they are working for the company. In a case such as that of Epistle Limited, taxpayers would be unlucky to be attacked by HMRC under the ‘Employment related securities’ rules.
HMRC’s attitude to income spreading
Some might consider the action of bringing in a new partner or a new shareholder purely to minimise tax as being a provocative act, which might trigger an attack from HMRC. However, there is no overriding rule of UK tax law that says that actions taken purely to save tax can be overridden or punished in any way by HMRC. There needs to be specific legislation countering the specific actions taken.
Furthermore, my own experience is that HMRC is not tending to target these sorts of basic family arrangements involving the business structure. Following the case of Arctic Systems, now nearly 15 years old, where the House of Lords agreed that a husband could divert income to his wife by issuing shares in the company, HMRC has generally been fairly quiet about this situation, at least as far as my experience and published cases are concerned.