Alan Pink highlights the merits and dangers of involving spouses and ‘significant others’ in a business to save income tax.
A time honoured and straightforward way of reducing your tax bill on a business’s profits each year is to move a slice of the profits, by one means or another, to a member of the household who is paying tax at a lower rate. Very often this is a spouse – and throughout this article, where I use the word ‘spouse’ you can freely substitute the words ‘civil partner’ because the rules are the same.
In what follows, I’ll be looking at the way the tax system treats such diversions of income, and will also briefly be looking at the differences between spouses on the one hand and unmarried partners and other members of the same household on the other. I won’t be considering the domestic and legal implications, but you should always bear in mind that tax isn’t the only important thing in life!
How to shift income
Let’s look at the simplest business structure first. John is a sole trader whose business is sufficiently profitable to push him into the higher (40%) rate of income tax. His wife Mary, on the other hand, has no substantial income of her own, and the couple subsist on the business profits.
In this situation, probably the commonest method of reducing the business profits, on which John is paying 40% tax, and putting in the hands of Mary, who will have her personal allowance and 20% band to offset against it, is for John to pay Mary a wage for helping in the business. This is very common in practice, and is often done with so little thought for any problems that it’s fair to call this ‘danger area number one’.
The first question any HMRC officer is going to ask, if he opens an investigation into the business accounts, is ‘are the wages actually paid?’ This may seem like an odd question, until you realise that a great many small business accounts are drawn up on the basis of simply putting figures in which seem reasonable, without reference to any actual flows of cash. So an accountant would put down ‘wife’s wages’ regardless of whether the husband actually paid these amounts to his wife as such.
The second question the HMRC officer will ask is: What does the recipient spouse actually do to earn the wage? If, as one suspects is too often the case in reality, this person does little or nothing, the wages could be disallowed for tax purposes under the ‘wholly and exclusively’ rule. A good acid test here is whether the business person would have paid an unconnected worker as much for the services which the worker is providing. So you are into tricky areas of judgment and the distinct possibility that the taxman will form a different judgment from you.
Give them a share?
For this reason, better advised businesses will often prefer the other option of bringing the other person into a share in the equity ownership of the business, by making them a partner. Basically, this way of moving income into the hands of a spouse is much harder for HMRC to attack, because there’s no ‘wholly and exclusively’ rule involved. So you don’t have to justify the amount of profit share your partner spouse receives from the business by reference to the work they do in the business in the same way.
Does this seem too easy? Perhaps it is, but except for one important point about the taxation of spouses, it does seem to be the law at the moment. Such law as there is on this subject is to be found in the ‘settlements’ provisions in ITTOIA 2005. Paraphrasing this, where income is diverted by a person (the settlor) in such a way that it can effectively still be enjoyed by the settlor or the settlor’s spouse (note my emphasis), the income will still be taxed on the settlor; that is, the diversion would have been ineffective for income tax purposes. In a case involving a limited company, but whose principles seem to apply just as much to partnerships, HMRC tried to make this stick against a taxpayer. This is the well-known ‘Arctic Systems’ case, where it was admitted that the husband did all the work and the wife did nothing for her 50% share of the income. But after a chequered career through the courts, the House of Lords eventually decided that this kind of diversion of income was quite within the spirit as well as the letter of the law.
The tax authorities, never good losers, immediately announced their intention to change the law, and put forward a suggestion that uncommercial diversions of income should be ineffective from husband to wife in these situations. This was the cue for well-orchestrated uproar on the part of tax practitioners, who objected that this would bring a completely subjective element into the preparation of tens of thousands of tax returns. The proposals were shelved ‘pro tem’, and never seem to have resurfaced. That was in 2008.
A pitfall for husband and wife partnerships
So the inevitable conclusion that you can draw from the above saga is that it is still ‘open season’ for tax planning involving giving a spouse equity in the business. But there is a trap you can fall into. One of the ways the legislation qualifies the ability to transfer income to a spouse involves the phrase ‘substantially a right to income’. Where this is what one spouse has given to the other, the transfer is ineffective under the settlements rules. But what does this phrase mean?
Basically, if (say) John brings Mary into partnership, but on explicit terms that she has no right to influence the way the business is run, has no share in the capital or entitlement to capital profits (for example if the business is sold) and only receives such income as John decides in his sole discretion to give her each year, the HMRC officer could well argue, in that case, that what had been given to Mary was no more than a right to income, and therefore her partnership profit share should still be taxed on John.
Of course, it’s very rare for such explicit terms to be put down in writing, but in theory the tax law applies just as much if this is the arrangement which can be inferred from the parties’ behaviour. So I would counsel steering clear of any restrictions at all of being placed on the spouse’s partnership rights; to be safe, make sure they are basically the same rights as those enjoyed by the ‘transferor’ spouse. This doesn’t mean that both spouses have to share profits, or voting control, equally. It merely means (for example) that a 40% share in the partnership gives 40% of the votes and 40% of capital profits, and so on.
Other business structures
Although I’ve been talking about a sole tradership and a husband and wife partnership throughout, very similar principles apply to businesses carried on through a company.
In a company, just as in a sole tradership, wages paid to a connected person need to be justified commercially. And if shares are transferred to a spouse, these should be ‘full fat’ shares preferably; that is shares which give full rights to voting, capital and income. I’m not saying that a restriction in these rights will necessarily be fatal to an effective diversion of income to the spouse, but it is dangerous.
Unmarried partners
Finally, I have been talking about spouses almost exclusively here, and not unmarried life ‘partners’. Are the rules the same for them?
Well, the rules relating to payment of wages are just the same; these need to be commercially justifiable. But paradoxically perhaps, in one important respect the rules for unmarried partners are much more lenient. The rule about transfer of equity shares in partnerships or companies not being ‘substantially a right to income’ doesn’t apply unless the recipient of the favour is married to the donor. So this is yet another disincentive to getting married embedded deep in our tax system.
