Paying ‘The Other Half’

Alan Pink considers the constraints applying to claiming ’spouses’ wages’ as a trading deduction.

Because income taxation in this country goes by individuals rather than households, a very common and long-established practice has existed of spreading income between spouses and other people sharing the same house. 

Very often in practice, you get the situation of two spouses, for example. One of them is the sole breadwinner in the household, conducting some kind of business activity. The other looks after the house and perhaps assists in the business. At its minimum, this might be answering the telephone when the breadwinner is out. Or, it may extend to a more active involvement in the business, including organisation of work and keeping accounting records. 

Needless to say, HMRC weren’t born yesterday. They know that a fairly worthwhile income tax saving can be enjoyed by putting in a figure for wages for the spouse (which is the term I’ll use from now on to include civil partners, unmarried partners and other close sharers of a household) where that recipient’s spouse has no income of their own; or perhaps pays income tax, but at a lower rate than that of the main breadwinner. So, historically, they’ve been very alert to the possibility of investigating the bona fides of these arrangements. 

For example, I once knew a husband who put in a claim for ’wages’ of about £7,000 for his wife every year. One year, the HMRC inspector decided to come around, not particularly to investigate this situation but just to look at the books. It was the first time the wife had been seen in the office, but she was very much in evidence, bringing papers, serving coffee, etc., on the date of the inspector’s visit!

But that, of course, was just an instance of ’window dressing’ or even camouflage of the true situation. The acid test in deciding whether a payment of spouse’s wages is permissible as a tax deduction tends to be taken as the ’third party’ question. If the person concerned was not otherwise connected with you, but you were paying them to do the job they do, would you pay them as much as that? If so, there is no problem, or at least there shouldn’t be. If you’re actually paying more than you would pay such an unconnected third party, this is where HMRC start getting interested. 

In a basic situation involving a sole trader business, excessive remuneration paid to a spouse is simply disallowed, and that’s the end of the story. Tax is paid on a greater sum than that shown at the bottom of the profit and loss account because some of the expenditure deducted in arriving at the profit is not permissible. But, of course, whilst ’simple’, this action on the part of HMRC can be extremely painful. As with all adjustments which they find on enquiry, the first, or perhaps the second, question that is asked is ‘how long has this been going on?’ Sometimes, indeed, the inspector doesn’t even ask the question but makes an assumption. If you’re one of the lucky ones, he might simply assume that you have been overpaying by a similar amount for the last four years, and slap assessments on you to extra tax for those four years. Added to the tax, of course, is interest for the earlier years, and you would probably be lucky to get away without a penalty as well. 

If the inspector is feeling particularly vicious, he can, in theory, go back over a much longer period, in fact, a period of up to 20 years. In practice, it’s left to the taxpayer to prove that the ’error’ hasn’t been going on that long, if it hasn’t. The taxman is going to put the onus on you as the taxpayer to show this.

For that reason, taxpayers should obviously be very wary about agreeing to any adjustment for the current year, because anything which is agreed will be multiplied by a factor of several, and then subjected to tax interest and penalties of punitive amounts. 

Where the excessive remuneration is being paid to the spouse of a director/shareholder in a company, the position is rather more complicated. If the payment is excessive, not only will it be disallowed in computing the company’s profits for corporation tax purposes but it is likely also to be treated as an effective distribution to the shareholder, resulting in income tax liabilities. This is because a ’distribution’ of a company is defined as any payment by the company to the shareholder, which is in excess of the value given back to the company by that person. 

An alternative consequence of excessive spousal remuneration in a company, which we haven’t seen invoked so often by HMRC, is to treat the payment as effectively remuneration of the main director, which has been diverted in some fashion to that director’s spouse. So, what the taxman would be saying here, effectively, is that the payment is really part of the main director’s remuneration, but has been paid to the spouse instead. If this was the line taken by HMRC there would, of course, be no disallowance for corporation tax purposes, because it would tend to be assumed that the main director (as opposed to the spouse) had actually earned an amount at least equivalent to this. But the flipside to the allowance in the corporation tax computation is, of course, that the main director would be liable for tax on the excess spousal remuneration at his own marginal rate. 

It may surprise those who aren’t used to the small business sector to hear that, very often, the problem with claiming tax relief for the payment of spouses’ wages is that the wages aren’t paid at all! It’s very easy, especially where a simple profit and loss account without a balance sheet is being prepared, for whoever is preparing the accounts simply to enter a figure for the spouse’s wages without actually pinning this down to any actual payments. Sometimes, the justification that is given for this practice is that the sole trader concerned must be paying his spouse some money, for example, for housekeeping, and one can easily simply categorise these payments as wages in order to justify putting in a claim for them in the profit and loss account. If the payments are below the threshold at which PAYE and National Insurance deductions are needed, there is obviously no formality about making these payments in any event; so why shouldn’t they be wages? 

Here, the Revenue have case law on their side. It was decided, in what is already a very old case, and you might say unsurprisingly decided, that where actual payments of wages are not made, there can be no deduction for those wages against the business profits. 

In my view, this is different, though, from the situation where the payment is not necessarily made in cash but is adjusted as an entry in the books of a business which keeps fully balanced records. A credit to a director’s current account with a company, for example, can definitely be taken to count as ’payment’ of the amount credited, providing it is available, in principle, for them to draw down out of the company. So, an accounting entry can count as ’payment’ for these purposes. 

The general moral of this, though, in particular the case we have mentioned, is that regular actual payments which are recognised as wages at the time and recorded in the business accounting records as such, should be made if you are to avoid HMRC attack on the grounds of non-payment of the spouse’s wages concerned.