Joe Brough considers how spouses and civil partners can be introduced into a business and tax traps to be aware of.
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When maximising the tax efficiency of married couples (or couples in a civil partnership), one consideration should be whether both spouses’ tax allowances are being fully utilised. Where there are unused personal allowances, or one spouse pays tax at a lower marginal rate, bringing a spouse into a business can provide access to tax efficiencies.
In the context of this article, spouse can also be taken to include ‘civil partner’.
Creating a partnership
A spouse can be introduced into a sole trade business by creating a partnership. One advantage of a partnership structure is that profits and losses can be allocated how the partners choose. This means that where one partner takes little or no part in the day-to-day running of the business, they can still be allocated a profit share.
This is subject to the rule that if the partnership has made an overall profit, neither of the partners can record a tax loss. Similarly, if the business is loss making, neither of the partners can record a taxable profit.
This flexibility means unused personal allowances and lower tax thresholds can be utilised first, which is useful where one spouse has other variable income sources. This flexibility is legislated for within the Partnership Act 1890, ss 19 and 24; however, profits cannot be varied retrospectively after the end of an accounting period.
Partnership settlements
On a basic level, the transfer of a share in the business to a spouse who may play a minor or inactive role will contain an element of bounty, such that a ‘settlement’ will have taken place.
However, HMRC confirms in its Trusts, Settlements and Estates Manual at TSEM4215 that where the incoming spouse acquires an unlimited share of the partnership assets, the settlements legislation will not apply; the gift will be covered by the spousal exemption in ITTOIA 2005, s 626.
Therefore, if a spouse receives a share of partnership profits without a right to the underlying capital, or is subject to reservation by the transferor spouse, the spousal exemption will not apply. Where caught, the profits will remain taxable on the transferor spouse.
Gift of shares
For a company, a spouse can become a shareholder via a gift of shares. The spousal exemption in ITTOIA 2005, s 626 is also available for an outright gift of ordinary shares. This was confirmed in Jones v Garnett [2007] UKHL 35 (commonly known as the ‘Arctic Systems’ case).
In the Arctic Systems case, it was found that whilst a settlement had been made by the husband in favour of his wife, the couple were able to rely on the spousal exemption as the shares were not wholly or mainly a right to income.
For the spousal exemption to apply to a gift of shares, the shares should ideally be of an ordinary class with full rights to dividends, voting and surplus assets on winding up. If the shares carry restricted rights other than a right to income, the spousal exemption will not be available, and any income paid on the shares will be taxed on the transferor spouse.
Employing a spouse
Rather than becoming a partner, the incoming spouse may become an employee instead. For a company, more flexibility is available as a shareholder can also be an employee.
For a payment of a salary to be a tax-deductible expense it must be incurred wholly and exclusively for the purposes of the trade. Where the wholly and exclusively condition is not met, the non-trade element of the remuneration will be disallowed in calculating trading profits.
This comes with the added downside that the full amount of remuneration will remain taxable on the recipient spouse, or possibly be subject to the settlement’s legislation.
In addition, the remuneration must also actually be paid to the recipient. In the case of a sole trader, crediting the remuneration against the drawings of the employer spouse is unlikely to satisfy the payment condition.
Ideally, a physical payment of the salary should be made. However, leaving the remuneration on a separate account which can be drawn down at any time by the recipient is likely to be acceptable.
When a spouse is employed, they are subject to the same rules as normal employees. Where there is a contract of employment, national minimum wage regulations apply, and any salary payments must be included on real-time information submissions.
Thinking ahead: Business asset disposal relief
BADR is available for a material disposal of business assets that have been held for a minimum two-year period. Potentially qualifying assets for BADR purposes include goodwill, property and shares in a trading company.
Where there is a disposal of shares, at the time of sale the shareholder must either be an officer or employee of their personal trading company. A personal trading company is one in which the seller holds at least 5% of the ordinary share capital, which gives them at least 5% of the voting and certain other rights.
If a business sale is anticipated, it is advisable to ensure that the qualifying conditions for BADR are met by all the owners. If a spouse has recently been introduced into a business, BADR will not be available if they do not satisfy the two-year qualifying holding period.
Where one spouse does not meet the qualifying conditions, but the other spouse does, a transfer of shares can be made to the qualifying spouse prior to sale. For BADR purposes, not all the shares must have been held for two years if the shareholder already has a qualifying holding
Example- share transfers
In October 2023, Philip transferred 50% of the ordinary share capital in his trading company to his wife, Jenny, by way of an outright gift. Jenny is appointed as a director, and receives a salary and dividend to utilise her basic rate band. The company was incorporated with 100 £1 ordinary share capital and commenced trading in 2010 with Philip as the sole shareholder and director.
Philip and Jenny have received an offer to sell their entire shareholding for £1m, with a proposed completion date of 31 March 2025. If completed on time, Jenny will not have held her shares for the required two-year qualifying period. As a result, capital gains tax will be payable as follows:
Philip Jenny
£ £
Disposal proceeds 500,000 500,000
Base cost of shares (50) (50)
Annual exemption (3,000) (3,000)
Taxable gain 496,950 496,950
Tax payable (10%/20%) 49,695 99,390
If, prior to the sale, Jenny transfers her shares back to Philip by way of an outright gift, BADR will be available on Philip’s entire gain. This is because prior to the transfer, he already holds a qualifying BADR interest in his own right.
Philip
£
Disposal proceeds 1,000,000
Base cost of shares (100)
Annual exemption (3000)
Taxable gain 996,900
Tax payable (10%) 99,690
By transferring her shares back to Philip, this results in an overall capital gains tax saving of £49,395.
Regulatory matters
Following a change to a business, there are a number of regulatory matters to update. Where a partnership is created, this includes the VAT registration. The VAT registration is updated by filing forms VAT 1 and VAT 2 with HMRC, along with form VAT 68 where the VAT registration number is to be retained.
For an individual receiving income such as dividends or profit share, this may trigger a requirement to file a self-assessment tax return. Where a partnership is formed, each of the partners will need to file form SA400, with the partnership filing form SA401. For a company director-shareholder, form SA1 should be used.
Where a business operates a PAYE scheme or is within the construction industry scheme, these registration details will also need to be updated to ensure the correct business structure is registered with HMRC.
Where registration for self-assessment is required, this must be notified to HMRC no later than 5 October following the end of the tax year in which the liability arose.
Practical tip
Introducing a spouse into a business should not be seen as a paper exercise. Whilst there are tax benefits available when creating a partnership or transferring shares, it must be remembered that the settlements legislation can render plans ineffective.
