Alan Pink considers whether it is better to take family or household members in as partners or pay them a wage.
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The basic idea behind this particular type of income tax planning is simple. Income tax being ‘a progressive’ tax, the rate at which you pay it leaps up when your total income for a year goes above a (comparatively) low threshold. To be specific, an individual with income of about £50,000 in a tax year will pay 20% income tax on the income above the personal allowance but below this threshold and will pay 40% income tax above that.
It is a long-standing anomaly (if you care to call it that) that in this country it’s individuals that are assessed to tax rather than households, because it does not take a Maths degree or even a calculator to work out that a household which has a single earner on £100,000 income will pay a lot more income tax than a household with two earners receiving £50,000 each. For this reason, they do it differently in some other countries; but in the UK, a method sometimes used to mitigate the effects of this dramatic hike in income tax liability is that of ‘spreading’ the income between a family of household members.
Small family businesses
I will be looking in particular at the position of a small business, receiving earned income from the provision of goods or services, and where there is typically one dominant individual behind the generation of that income; tax planning by way of income spreading amongst members of the household can be particularly apposite in such business situations. And I will also be looking to answer the question: “How, precisely, should I do it?”
Fundamentally, most people in this situation, who have other family members to share their income with, have two ways to structure the process of sharing out the income:
- By paying a wage or salary to the other individual.
- By bringing that other individual into partnership and giving them a share in the profits.
Let’s have a look at the tax and some other implications of this choice.
The tax ‘hassle’
In theory, of course, you have no choice as to whether to treat this other individual as an employee or a self-employed partner. The true legal position will be one or the other, depending on how you are related to the individual; but having said that, in practice, there’s quite a lot of leeway and of course, you can actually change the way that you relate to the individual to bring the relationship into the desired category, in many cases.
If you take on your fellow household member as an employee, the administration can be very simple provided you pay them below the PAYE and National Insurance contributions (NICs) threshold, which currently is just under £10,000 a year. Even in this case, you should not make the mistake that some corner-cutting taxpayers have made in the past, and simply write down the wage ‘paid’ to your spouse (say) without actually handing over the money to them. HMRC can and do seek to disallow ‘paper’ wages.
The alternative, of bringing the individual in as a partner, does not come with the significant administrative penalty of having to apply PAYE deductions etc., if you go over the threshold. The corresponding administrative obligation is for the individual to register for self-assessment (if they have not already done so) and put their partnership profit share down on a tax return each year. In most cases, this is likely to be much less onerous than going through the PAYE treadmill.
Does it work?
Much more important than the question of how much administrative hassle you are letting yourself in for, though, is the question of whether the income spreading planning is even effective.
Let me explain what I mean. If you pay your wife, husband, boyfriend, girlfriend or child a wage for doing a job, HMRC will expect it to be just that. In principle, they can ask you for a detailed explanation of what the person actually does for their wage, and if they form the view that you are paying them more than the actual work justifies, simply because they live with you, they are likely to argue that some or all of the ‘wage’ should be disallowed as not being ‘wholly and exclusively’ for the purposes of the business.
This is where there is an interesting contrast between paying a wage to someone and giving them a profit share as a partner. Whatever the higher-blown technicalities of the situation may be, there is not anything like the same pressure, in practice, to show that a partner does something (or anything) for the profit share they receive. The ‘wholly and exclusively’ rule does not apply to an amount that you allocate to a fellow partner in a partnership because it is not being claimed as a deduction in arriving at the profit, but just an appropriation of the profit that has been made.
To sum up, in cases where the person who you want to endow with some of the profits, to save tax, does little or nothing in the business, your only sensible choice is to bring them into partnership. Pay someone a wage for doing nothing, and you are riding for a fall.
Non-tax implications
As with any kind of business arrangement like this, which is designed to save tax, you need to be very conscious of the non-tax implications of what you do, as well.
Looking at it for a moment from the point of view of the ‘other family member’, there’s a big difference, potentially, in non-tax terms, in your status as an employee as compared with a partner in the business. Assuming that we are talking about a straightforward partnership here, rather than a limited liability partnership (LLP), which is a completely different beast, one not entirely unimportant by-product of becoming a partner in a business is that you become unlimitedly liable for all its debts. So, if anything goes wrong, and the business ends up being wound up or insolvent, all your assets, including those outside the business, are vulnerable to a claim by the business’s creditors.
The situation is quite different, of course, for employees; unless they have done something specifically wrong themselves for which they can be held to account, there is no general liability for what the partners running the business do.
I know my rights!
Another non-tax based difference between the two ways of structuring things derives from the legal relationship between you and the other person, and the legal rights that derive from that.
Looking at it all round, and in general terms, it’s a dog’s life being an employer; or so a large number of employers consider. The feeling they get is that the law is very much on the side of the employee and against them (e.g., in the inability to get rid of somebody who does not do their job properly, unless the shortcomings are absolutely flagrant); or the rights to claim compensation for unfair dismissal; and to demand that certain benefits and working conditions are provided.
You may say that this is not particularly relevant in the case of Mrs Jones employing her husband to answer the phone and keep the books; but all these legal rights only become relevant, of course, by definition in situations where the parties fall out. If family and household members never fell out together this would not be a problem; but welcome to the real world!
Practical tip
Of course, being someone’s partner also brings with it specific legal rights, and it’s important if you go down this road (I would suggest) to define very carefully what the rights of the respective partners are, even if it’s all within a close-knit family relationship. For no other reason, tax consequences of bringing in partners, such as (except between spouses and civil partners) the capital gains treatment of the goodwill when you bring in another partner, needs to be considered and carefully agreed (and preferably minuted in writing). Also, as any lawyer would suggest, there should be the relevant provisions for dissolving the partnership should things not work out.
