Spouses and civil partners: Employee or business partner?

Lee Sharpe looks at one of the best tax planning arrangements around – engaging other family members in one’s business.  

This article looks at the main issues when considering whether or not to engage one’s spouse or civil partner in one’s business, as a partner or as an employee.  

While the article focuses on the tax aspects of such arrangements, note that there are non-tax issues to consider – a business partner is not the same as an employee! This article includes basic principles according to the law as it applies in England and Wales; the legal framework for partnerships in Scotland does differ in the detail. Tax rates and bands are for 2020/21, so far as currently established at the time of writing. 

Main aim 

While spouses (and/or civil partners) are taxed independently of each other, their incomes are generally treated as being pooled when tax planning. So, if it is possible to make use of a spouse’s tax-free personal allowance and/or lower tax bands, and where tax rules permit, it should be quite beneficial overall.  

Example 1: Salary share to spouse 

Aisha and Orla are married. Aisha owns an engineering business and earns £80,000 a year in pre-tax profits. Orla currently has no income but is a qualified CAD technician and could do valuable work for Aisha’s business.  

Give Orla 50% Salary 

Total  for  Aisha  50%  and  Orla  50%  =  £31,601  + £28,263 = £59,863. Net saving against Aisha only is £3,767. Reconciles to tax saving £9,257 and a NIC cost of £5,490.

Example 2: Profit share to spouse 

Suppose that Aisha (in Example 1) decides to make Orla an equal partner in the business, instead of an employee.  

Give Orla 50% business profits 

Total for Aisha 50% and Orla 50% = £31,596 + £31,596 = £63,193. Net savings against Aisha only are £7,096. Reconciles to a tax saving of £8,500, the NIC cost is £1,404.

Giving Orla a 50% share of the business profits as a partner increases the couple’s net annual income by just over £7,000. This is almost double the increase that would be seen if Orla were to draw an equivalent salary from the business instead of profit share; the main difference here can be attributed to employers’ NIC, which has to be paid on top of whatever gross salary Orla takes. 

In either case, the initial income tax saving is partly offset by an increased NICs cost (although it is clearly worse going down the employed salary route). Given Aisha’s initial level of profits, the top £30,000 of her profits is suffering only 2% NICs but if the income is instead split between her and Orla, it will mostly be subject to the ‘full’ or main rate of NICs assessed on Orla instead. 

The outcomes would be quite different if (say) Orla already had taxable income, or we were talking about only a small salary or profit-share. If Orla were to take (say) £10,000 as either profit or salary rather than £40,000, the NICs cost to Orla would be little more than £200 but Aisha’s would a bit over £4,000, meaning they would be around £4,000 better off overall.  

Other tax considerations 

As with all family members, it must be possible to justify a spouse employee’s salary in terms of the work they do. Paying a spouse or civil partner £50,000 a year for half a day’s filing per week might well be challenged as being excessive. It could, therefore, be disallowed for tax purposes to the extent that it has not been incurred ‘wholly and exclusively’ for the purposes of the trade or business; see HMRC’s Business Income manual at BIM37707 et seq. To the extent that the disallowance is disallowed, it will revert to taxable profit – the business owner’s income. 

In contrast, it is possible to vary the share in profits between partners as they see fit – although it is forbidden to do so retrospectively. HMRC states (at BIM82065): 

“You cannot challenge the apportionment of profits, as you can a wage, by reference to the value of the partners’ contribution to the firm’s activity... It is sometimes overlooked that there is no need for the spouse or civil partner to contribute capital; or to participate in management; or, in a trading context at least, to be capable of performing the main activity of the business. Indeed, to be a partner, one need not take an active part in the business at all... 

It is worth emphasising that a partnership is not a sham merely because it is set up to save tax, as indeed the spouse or civil partner who is deserted by a partner leaving them to meet the firm’s liabilities may find to their cost.” 

So, it would seem that partners afford much more flexibility than employees. But it is not all one way; for example, HMRC’s manuals also state that it may be possible to invoke the ‘settlements’ anti-avoidance legislation, effectively to tax one partner’s profits as really belonging to the other partner, where it is only income that has been diverted (see the Trusts and Estates manual at TSEM4215).  

However, even HMRC acknowledges that this argument is difficult to sustain where the partners also have rights to partnership assets or capital, rather than only to profits, thanks to special protections in the settlements regime afforded to spouses and civil partners. 

There are also some advantages to taking on a spouse or civil partner as an employee: 

• It is possible for the employee to ‘earn’ the NICs credit towards state pension entitlement with relatively little or no cost. 

• As regards private pension contributions, an employee’s wage or salary will practically always count as relevant earnings so that substantial contributions might be made. But the profits of a property letting business or similar investment activity do not count as relevant earnings and will not enable contributions of more than £3,600 per annum.  

Other considerations 

Aside from the numerical aspects involved, note that a business partner generally has more powers than a ‘mere’ employee. This can include rights to business capital, as well as a share in business profits. A business partner can legally commit or ‘bind’ the partnership to business deals; for example, in Kotak v Kotak [2017] EWHC 1821, one of the business partners had emigrated, and the remaining partner signed up for bank loans to which the first partner subsequently objected; the High Court ruled that the remaining partner had indeed committed the partnership to the loans and the agreements should stand.  

It could be argued that a sole trader’s spouse or civil partner already has significant rights over assets by reason of the marriage or civil partnership itself, but practically speaking general business partners will have those rights on a day to day basis. It may, therefore, be advisable to have a partnership agreement in place – even between a couple – to ensure that each partner’s rights and responsibilities are clearly defined (but see the point above about the settlements anti-avoidance legislation; excessive curtailment of rights could be counterproductive). 

Alongside those powers, however, is the fact that general partners are jointly and severally liable for a partnership’s debts. For example, if the partnership owes a supplier £1,000,000 and cannot afford to pay, the supplier is basically allowed to seek up to £1,000,000 from each partner, individually, until the debt is satisfied. 

An employee, on the other hand, has no liability for the partnership’s debts but does have numerous rights, such as to minimum wage, sick pay, holiday, pension, etc. 

Conclusion 

The above examples demonstrate that in terms of straight calculations, distributing income more evenly between a married couple or civil partnership is likely to be beneficial; depending on the particular circumstances, and how much the spouse wants (or is at liberty) to take, one route may be significantly better than the other. But it is not always about tax. 

For instance, assets and wealth held personally by a spouse or civil partner are potentially at risk if they become business partners, in a way that they would not if they were merely employees. Couples should seek advice beforehand and ensure that it is updated from time to time, especially if circumstances change significantly.