Family Tax Planning
From the Arctic Systems case and Income Shifting to paying your children a wage.
In this helpsheet we're going to look at the main ways of tax planning with the use of family members...
Paying wages to your spouse/civil partner and children through your business
Your spouse/civil partner may not have any income at all, and almost certainly your children don't. This means their personal allowance is being wasted every year. Even children are entitled to a personal allowance.
If the amount up the level at which national insurance becomes payable of £9,568 in 2021/22 was paid to them as wage, they would pay no tax on it and your business profits could be reduced.
Please note that children under the minimum school leaving age can only work a limited number of hours per week and local by-laws may restrict them further
If you pay just 20% income tax and 9% Class 4 National Insurance on your business profits this would save you £3,053.00 in 2021/22 on each salary. And how many children do you have?
STOP! It is not quite that simple. To pay wages like this you need to follow the following rules...
It must be for work actually done. Now it is going to be tough to argue your 2-year-old son is working for you but many spouses/civil partners do work and mature children may also help out. May be they do the books, answer the phone, stuff envelopes, etc. Keeping out of your way so you can get on does not count, as valuable as it may be. Draw up a list of their responsibilities to help your case. At present they do it for free because it is a family business but they can be paid for it. If you make your spouse a director, all the responsibilities imposed by Company Law on taking on this role must be worth something. You can also pay a family member a wage where you have property that you rent out and the individual manages the properties. It is reasonable to pay them a salary commensurate with what they actually do. How much would it cost to get someone in to do that job? The national minimum wage level is at least a good place to start but a higher wage can be paid if you can justify it.
The amount must actually be paid. It is no good the accountant just putting it through the accounts at the end of the year. Pay it, ideally through the bank rather than cash so that it is easy to prove it is been paid and record it in your accounting records.
Comply with any PAYE procedures as you would do for normal staff. It may also help keep up their National Insurance contribution record even if they don’t pay any National Insurance on the salary.
Making your spouse/civil partner a partner or shareholder in your business to reduce your tax bill
There was the so-called Arctic Systems case involving Mr & Mrs Jones which was finally won by the taxpayer which is very relevant here.
The basic idea is that income that is created by your efforts in the business is paid to your spouse/civil partner who pays lower rates of tax than you do, thus saving tax and NI for the whole family.
For example, for 2021/22 if your self-employed business had profits of £80,000, then £50,270 is taxed at basic rates but the remaining £29,730 of this is taxed at 40%, plus 2% NI. So by introducing your spouse/civil partner into the business they can pay basic rate tax on profits that would otherwise be taxed at higher rates.
As with many things in the tax world, it's not always that simple. The major obstacle the Revenue had been trying to put in the way is what is known as the "settlements legislation".
In a nutshell this says if you give something to your spouse that is not wholly or substantially a right to income (meaning that the subject of the gift has a capital value as well as an income producing element), any income that does arise will be treated as the spouse's income for tax purposes.
The present law following Arctic Systems is that if you give your wife some ordinary shares in your company or perhaps a share in your partnership, this is not just a right to income but it also contains capital rights, as by owning the share they become entitled to a proportion of the assets when the business is closed down and have voting rights . Therefore the share is not just a right to income.
The actual facts of this case that was finally won by the taxpayer at the House of Lords and cannot now be appealed are as follows...
Mr Jones set up Arctic Systems in 1992 through which to offer his services as an IT contractor. He was the only director and held one of the two ordinary shares issued by the company. Mrs Jones purchased the other ordinary share from the company formation agents, and also became the company secretary.
They acted on advice from their accountant to take minimal salaries from the company, and pay out most of excess profits as dividends. As Mr and Mrs Jones held the shares equally, the dividends were paid to them equally and were mostly covered by their basic rate tax bands, meaning little higher rate tax was paid. If Mr Jones had paid himself a higher salary, or had been the only person receiving a dividend, he would have paid far more tax as much of his income would then have been taxed at the higher tax rate of 40%.
This type of arrangement has been standard tax planning for many husband and wife companies since the introduction of independent taxation for spouses in 1990. It was even recommended on the Business Link website! However, the Taxman decided to attack the arrangement, saying Mrs Jones only received her share, and the dividends paid on that share, because of Mr Jones work and the decisions he took as a director. The argument was that Mr Jones had effectively made a gift of half the earning capacity of the company to Mrs Jones, and because she is his spouse, the tax law says he automatically benefits from the gift, and thus Mr Jones should be taxed on all of the dividends.
The House of Lords actually agreed with the Taxman that the shareholdings in the company had been set up to minimise the tax paid by Mr and Mrs Jones. However, because the gift by Mr Jones had been made to his wife, and the gift was not restricted to the earning capacity of the company, but included future rights to capital on liquidation, and the voting rights associated with the ordinary share, there was a get-out clause. This get-out clause only applies to married couples and civil partnerships, and says that if you make a gift to your spouse/civil partner (which comprises more than just income), and there are no strings attached, you should not be taxed on the income arising from that gift.
Mr Jones had allowed Mrs Jones to buy half of the company (the other ordinary share) for a very small sum. This did amount to a gift, but the gift was covered by what is known as the "spouse exemption", so Mr Jones could not be taxed on the dividends arising from Mrs Jones' share. The Taxman went away red-faced, and the taxpayer was victorious!
For many years, accountants up and down the country have been using this so called loophole and the Arctic Systems case has clarified the law.
However The Taxman is a bad loser, and after a big defeat like Arctic Systems is now looking to change the law.
The day after the House of Lords judgement the Treasury minister under the previous Government said they would act against couples who indulge in income splitting in an unfair way.
The description of this unacceptable behaviour was given as income shifting, defined as where one person diverts their income to a second person who is subject to tax at a lower rate, to obtain a tax advantage. Whilst nothing has yet happened, the 2007 Pre Budget Report indicated that new legislation to tackle income shifting would take effect, but it will only apply to income paid in the form of company dividends or partnership profits. Thus paying your spouse a fair salary for work done would not be attacked.
The income shifting rules were to take the following into account:
The work done in the business by each individual;
The amount of capital contributed to the business; and
The business risks each person takes.
However, in light of the recession, the introduction of income shifting rules were postponed, to be kept under review.
So what can you do to improve your case in anticipation of the law being changed at some point?
The main problem can arise where the company is based on the work of just one of the married couple, such as a computer consultant. The spouse/civil partner doesn't work in the business and the company has no goodwill value without the computer consultant or any other assets to give it a capital value.
If your spouse/civil partner has become a shareholder or partner for legitimate reasons it will still be safe to do in future.
It is important that the gift of shares or partnership is an outright gift with no strings attached. Otherwise it will not count.
This can however be one of those grey areas mentioned earlier and you should get further advice from your accountant in your own situation as every case here will be different.
To help your case when the law is changed it means doing everything you would do as if this was a real commercial arrangement and not just because it is your spouse/civil partner. For example, having a partnership agreement, amending bank signatories, letterheads, telling suppliers, the VAT man, etc. If possible, also get your spouse/civil partner to introduce some money into the business.
We don't yet know how the new law would fully work but it is quite likely that by looking to put in place the following items you will help your case if the law is changed:
Avoid formal arrangements and contracts of employment.
Have no pre-arranged policy on salary levels or dividends.
Make both spouses/civil partners directors, and consider make your spouse the Chairman with the casting vote on the board of directors.
Maximise and document the efforts of the non fee-earning spouse/civil partner.
Consider an outright gift of shares to the non fee-earning spouse/civil partner before the business becomes profitable.
Tone down any description of your business activity in your accounts as being a "one man band" - but don't be misleading. Create a more corporate image.
Avoid having different classes of shares particularly non-ordinary shares that have less capital value. You want ordinary shares in the company whose rights are not restricted in any way.
Make sure all the paperwork is right and stacks up re Companies House forms, dividend resolutions, etc.
Consider transferring assets into the company in return for a new share issue to uplift the capital base of the company.
Don't pay out all the profits in dividends. Leaving some cash in the company increases the impression of capital rather than income, especially if this cash is invested for the medium term.
Ensure any dividends paid to a non-working spouse are paid into their own personal bank account.
Consider giving more than 50% control of the business to the spouse/civil partner.
Other relatives and non-married couples
For non-married couples, who involve other relatives such as brothers, sisters or grandparents, in the business, the settlements legislation does not apply in the same way. The specific loophole applies only to spouses.
However, if the donor (that's you) retains no interest in the gift, the income will not be assessed on them.
This may be hard to substantiate where you and the done are cohabiting and share bank accounts and living costs.
Giving investments to your spouse/civil partner and children
You should also look at your investments to decide if it would be better for your spouse/civil partner to own them so that the income is assessed on the spouse.
For any jointly held investments with your spouse/civil partner (other than shares in the family company) they are treated as being owned 50/50 for tax purposes, however actually owned, unless you make an election to the contrary.
Any gifts to your children who are aged under 18, which result in them receiving an income, will still be classified as your income for tax purposes apart from the first £100 of income each year.
How We Can Help You
Family tax planning, especially when trying to share the profits of a business is very complex and we can advise you on the best strategy in your own circumstances.