Alan Pink considers the choice between employing your loved one and making them a partner.
It has been common practice since time immemorial for someone in business to employ their spouse, often on a fairly nominal wage, simply to get a tax advantage. If that spouse (or civil partner; the two are generally interchangeable for tax purposes) is not a taxpayer or is paying tax at a lower rate than you, it gives you an obvious advantage if you can effectively divert some of the business profits to that other person.
Often the view is taken that it’s quite sufficient just to write a number in the profit and loss account for ‘wife’s wages’ (or equivalent), but people have come unstuck with this casual approach. HMRC has been known to quote case law in favour of disallowing ‘wages’ that aren’t actually paid. The rest of this article, though, assumes that the wages would be validly paid and, if they are enough to trigger PAYE and National Insurance contributions (NICs), that those deductions would have duly been made.
But there is a valid alternative to making your other half an employee of the business, which is to admit them as a partner, and this is also a highly popular alternative. Which is better: to employ them or to make them a partner? Let’s look at the various factors in the equation.
National Insurance contributions
NICs are much lower if you make them a partner because generally, they’ll be treated as self-employed as a partner in the business. If a person is treated as an employee, and their earnings are over the threshold, they would give rise to two different sorts of NICs: a 13.25% deduction, and on top of this, the employer must pay employer’s NICs contributions, which are now 15.05%.
The self-employed rules are much more lenient, with Class 4 NICs of 10.25%, payable out of the individual’s self-employed earnings; and importantly, there’s no equivalent at all, in the self-employment sphere, of the fairly swingeing employer’s NIC contributions. What makes things even worse for the employment alternative is that employer’s NICs (despite its name) appears not to give rise to any entitlement to state benefits for the individual concerned; arguably, it’s nothing more nor less than a payroll tax.
So, in almost all cases, NICs is pointing very firmly in the direction of the partnership option.
Red tape
The formalities are also quite different between the two alternatives. If you are an employee, your employer has to go through the requirements of operating a PAYE system, with all its paraphernalia of deduction tables, payslips, and year end returns to HMRC.
The partnership option is not completely free of red tape; the individual who becomes a partner has to register for self-assessment and do a tax return showing their profit share derived from the partnership return. So, if a sole trader (A) brings their spouse or civil partner (B) into the partnership, one moves from having one tax return to do each year, to having three; the partnership return and those for the two individuals. But generally, it’s true to say that this self-assessment hassle is significantly less than the employer must go through when paying someone above the PAYE threshold.
Often far more important than either of these is the the amount of wages paid to a spouse or other close family member. HMRC’s officers weren’t born yesterday of course, and are well aware of the income tax advantages of diverting profits of a business to someone who pays tax at a lower rate. If you pay your spouse or civil partner an excessive amount (i.e., more than you would have paid an unconnected person for the job), HMRC can disallow the excess on the basis that it isn’t incurred ‘wholly and exclusively’ for the purposes of the business.
With partnership, there’s no equivalent to this rule, although the settlements rules (which I’ll come on to) are a bit of a minefield. In practice, though, it seems that the amount of income allocated to a partner who is the ‘main’ person’s spouse or civil partner does not come under the same scrutiny from HMRC.
Who pays?
Finally, and moving away from the tax aspects (which, as we’ve seen, generally favour partnership over employment) there’s the question of liability. Although, in theory, employees can get into hot water financially for things they do wrong in the course of carrying out their work, it’s a whole different ball game when you become a partner, as far as liability is concerned. As an ordinary partner in an unlimited partnership, you can be made liable, potentially, for all the debts of the business, however caused, and even if you had nothing to do with the incurring of that liability.
Looking at it from the point of view of the individual who is considering bringing their spouse or civil partner into business partnership, there could be something to be said for leaving that person in a kind of safe area of non-liability because you certainly do not want both spouses or civil partners to be made bankrupt in the event of a financial cataclysm!
Limited liability partnerships
This last point, about the potentially disastrous financial effects of making someone a partner, leads on to the question: is a limited liability partnership (LLP) the answer? LLPs were first introduced at the instigation of large firms of accountants who wanted the tax benefits of being partners rather than employees but were fed up with being sued for what some other individual, perhaps somewhere else in the world even, had done wrong.
To some extent, it’s true that the LLP structure (which is that of a body corporate taxed as if it were a partnership between its members) can give you that ‘best of both worlds’ situation, but it does introduce a new set of criteria that you have to be very careful of. To get the NICs and other tax benefits of being self-employed that I’ve mentioned, members of an LLP (the equivalent of partners) must meet one of three specific statutory criteria:
- The LLP agreement must give them a ‘significant influence’ over the way the LLP is run; or
- They must have capital invested in the LLP equivalent to 25% of their expected annual income; or
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They must have a variable element of their income which equates to 20% of their expected annual income – with the variable element being determined by the profits of the LLP as a whole (and not, for example, simply by reference to their own input into the LLP’s business).
These rules are highly prescriptive in comparison with the regime that applies to ordinary, general or unlimited partnerships (the terms are synonymous here).
The ‘settlements’ rules
I mentioned earlier the tricky situation regarding diverting income to a spouse who was not necessarily earning all of it. On the face of it, the ‘settlements’ rules, which are actually stricter with regard to spouses or civil partners than with regard to other relationships, however close, could have the effect of the ‘transferee’ spouse’s (etc.) income being taxed, as if the diversion had not happened, on the ‘transferor’ spouse.
The latest authority we have on this is still the Arctic Systems case, which was decided in 2007 in favour of the taxpayer by a fairly narrow margin. That case basically decided that, in a limited company context, there was nothing stopping a husband from transferring shares to his non-working wife and the wife then receiving dividends which were her income, and were not attributed to him under the settlements rules.
Practical tip
Despite the announcement that HMRC was going to change the rules shortly afterwards, the rules never were changed, and at the moment it could be seen as being ‘open season’ for diverting income to a spouse in this way by bringing them into partnership or shareholding in the family company. But as to what HMRC might do in the future, who knows? They probably do not even know themselves.
