INTRODUCTION

 

Can an individual split business income with a spouse/civil partner to reduce tax on profits?

By sharing income both spouses/partners can use their tax-free allowances and lower tax rate bands against their share. The same is true for NI contributions. Before we look at how they can achieve this with different sources of business income, e.g. companies, trading partnerships, it’s worth understanding the amount of tax savings at stake in general terms.

Example

Jack and Jill have been married for several years. For 2022/23 Jack’s earned income is £80,000 and he has no other income. Jill has no income at all. Neither is entitled to tax allowances or reliefs other than their personal allowance.

The table below shows the tax bill where all the income is Jack’s.

The example below uses income tax rates and bands applicable to English, Welsh and Northern Irish taxpayers. Slightly different rates apply for Scottish taxpayers, but the principles for calculating their tax liabilities are the same. Details of all UK income tax rates are included in the Appendices.

Table 1

Jack	£	£
Income tax
Income	80,000
Personal allowance	12,570
Taxable amount	67,430
Tax at 20% on	37,700	7,540
Tax at 40% on	29,730	11,892
Total tax		19,432

 

The table below shows the tax bill where the income is divided equally between Jack and Jill.

 

Table 2

Jack and Jill	£	£
Jack
Income	40,000
Personal allowance	12,570
Taxable amount	27,430
Tax at 20% on	27,430	5,486
Jill
Income	40,000
Personal allowance	12,570
Taxable amount	27,430
Tax at 20% on	27,430	5,486
Total tax for Jack and Jill		10,972

 

The tax saving on annual earned income of £80,000 if the income is split rather than received by just one spouse is £8,460. Over, say, five years, assuming the same tax allowances and rates it is £42,300.

Warning. NI contributions are also affected by income splitting. However, the position for these is less straightforward. It can result in higher or lower NI bills. It depends on the amount of income, its nature, e.g. salary, profits, dividends, and how the couple divide the income, e.g. 50/50, 75/25, etc. It’s not possible therefore to give a general example of the NI position when income is split. Instead, we’ll consider it when we look at the effects of splitting different types of income.

 

Can all business income be split?

Yes, in theory. It can be achieved by paying a salary, providing benefits in kind or distributions of profits from a company or from an unincorporated business. However, it’s not always possible or may not save tax or NI (in fact, it could increase a couple’s overall tax bill) so planning is important. Unless there’s a non-tax motive there’s no point in splitting income if it will increase the joint tax liability.

The consequences of sharing earned income with a spouse/civil partner depend on the source of income, namely whether the business is:

• a sole trader (self-employed)
• a partnership (including a limited liability partnership (LLP)); or
• run through a company.

Although they have common issues there are significant differences, especially for businesses run through a company. We’ll look at the options for each type of arrangement.

SOLE TRADERS

As a sole trader (self-employed, freelance) the individual alone is taxed on the profits of the business. They cannot allocate a share of them for tax purposes to anyone else. If they choose to assign some of the profits to a spouse/civil partner (or anyone else), simply by transferring some money to their bank account, the trader is still liable for the income tax and NI contributions. In effect, the profits assigned are net of these deductions.

Instead, a trader can divert income to spouses/civil partners by paying them for work they do for the business. They can do this by:

• employing them and paying a salary
• paying them for work they do for the business on a freelance (self-employed) basis.

 

In what circumstances can a trader pay a spouse/civil partner as an employee?

If a trader plans to pay their spouse/civil partner as an employee, they must be employed. Employment comes with a raft of rules and regulations relating to tax and employment rights. There are some small concessions from the usual rules, but in general the trader must treat the spouse/civil partner as they would any other employee.

Therefore, if the trader employs a spouse/civil partner there should be a contract of employment and they should pay them a salary that is appropriate for the work they do for the business. The last point is especially important because, like all business expenses, they are only entitled to deduct the cost of employing someone from the profits if what they are paid  is “wholly and exclusively for the purpose of the trade”.

 

Can a trader pay the spouse/civil partner below the minimum wage?

Members of an employer’s family who are living in the employer’s home are not covered by the national minimum or living wage (NMW/NLW) rules. The trader can pay at that rate, above it or below it. This is significant for tax planning purposes. For example, the trader can set their pay at the most tax-efficient level.

Income shifting only saves tax where the recipient spouse/civil partner pays less on the same income. That seems obvious, but it’s often overlooked because it’s assumed the more income shifted the greater the tax and NI savings.

NI contributions can be saved by keeping the income shifted within the NI lower thresholds. Even if there’s no tax saving there can be one for NI.

Because the trader is not bound by the minimum wage rules they can set the spouse/civil partner’s salary at any rate.

If the trader pays their spouse/civil partner as an employee, they must include them on the payroll as they would any other employee. They also have the same workplace pension rights as other employees.

HMRC may attack arrangements where the spouse/civil partner’s salary is not paid but only recorded as an expense in the business records. They should be able to point to a transfer of money that tallies the sums recorded as the spouse/civil partner’s pay.

 

Can the trader pay the spouse for ad hoc work?

If the spouse/civil partner does occasional work for the business, the trader can pay them as a casual employee. This usually involves including them on the payroll but because of how PAYE works they might not have to account for tax and NI. Alternatively, if the conditions and terms of the work mean they aren’t a casual employee, the trader can pay them as a freelance (self-employed) worker. This means they don’t have to worry about PAYE etc.

 

What’s the tax treatment of benefits in kind?

Where the business provides benefits in kind, e.g. a car, for use by the spouse/civil partner they are taxable in the same way as benefits provided to employees not connected with the trader. However, there is an exception for benefits provided to family members of a sole trader where they are provided in the course of their “family, domestic or personal relationships”. However, the cost of such a benefit isn’t tax deductible for the business because it’s not “wholly and exclusively for the purpose of its trade”, i.e. because it’s personal.

Certain benefits in kind are exempt from tax, e.g. trivial benefits. Traders employing their spouse/civil should take advantage of these by providing them as part of the salary package. That way they are tax deductible for the business and tax and NI free for the spouse.

 

Is there an advantage to paying the spouse as a freelance worker?

Unlike paying a spouse/civil partner as an employee, there is no employers’ NI liability for the business if the trader pays them as a freelance (self-employed) worker, plus their NI liability can be slightly lower too.

The trader can only pay them as a freelancer if the terms and conditions under which they work for the business are such that they aren’t categorised as an employee, i.e. caught by IR35. Traders can use HMRC’s “check employment status for tax” (CEST) tool to help decide if the spouse/civil partner is employed by the business or is a freelancer. The CEST tool is available from https://www.gov.uk/guidance/check-employment-status-for-tax.

 

PARTNERSHIPS

Can a sole trader create a partnership with a spouse/civil partner?

Yes. It can be a very tax-efficient arrangement which is difficult for HMRC to attack.

HMRC often attacks income splitting arrangements that involve one spouse/civil partner paying the other a salary to reduce their business profits, unless the salary paid can be justified as proportionate to the work they do for the business. By contrast, HMRC rarely attacks arrangements where profits are diverted to a spouse/civil partner by making them a business partner. There’s a good reason for this. The existence of a general partnership (including a Scottish partnership, but not a limited partnership nor limited liability partnership (LLP)) is determined by the Partnership Act 1890. Tax law cannot override this. However, HMRC does have anti-avoidance rules which counter some of the more extravagant tax-avoidance arrangements using business partnerships, including those between spouses/civil partners.

 

How does the couple create a partnership?

There’s no prescribed way to set up a partnership with a spouse/civil partner. A partnership will exist if the circumstances fit the Partnership Act 1890. It says a partnership is created simply by two or more persons sharing business profits. Specifically, it says a “Partnership is the relation which subsists between persons carrying on a business in common with a view of profit.” Some activities which generate income which is shared do not alone count as a partnership:

• owning assets jointly
• sharing income from jointly owned assets
• a share of money received from a business which may vary according to its profits, for example, a self-employed agent for a partnership entitled to a payment based on a percentage of its sales, or a former partner entitled to an annuity linked to the partnership’s performance.

The couple can avoid any doubt over the existence of a partnership by forming an LLP or limited partnership. The drawback with these is that they can involve significantly more administration, e.g. the need to file accounts with Companies House.

While there is no need or system for registering a general partnership, the couple will need to notify HMRC if they create one so that it can issue a tax return for the partnership. The partners are also required to complete a self-assessment tax return including the special pages for declaring their partnership income. For more information, visit https://www.gov.uk/set-up-business-partnership/register-partnership-with-hmrc.

Notwithstanding that it’s difficult to challenge the existence of a partnership, drawing up a partnership agreement to formalise the arrangement is advisable.

 

How does HMRC view business partnerships between spouses/civil partners?

It’s difficult for HMRC to dispute the existence of a general partnership and, consequently, how its profits or losses are shared between the partners. In fact, HMRC’s internal guidance says, “It may be possible in these cases to challenge the spouse or civil partner’s status as a partner, but such a challenge is often very difficult to sustain.”

Having cleared the initial hurdle of creating a partnership, the couple might still be concerned that HMRC could attack the arrangement where they split the profits to avoid tax. Surprisingly, HMRC’s guidance helps again. It says, “A spouse or civil partner is sometimes taken into partnership wholly or mainly to maximise the benefit of the tax reliefs that are available”. It continues, “It is worth emphasising that a partnership is not a sham merely because it is set up to save tax” and “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”. 

While HMRC can’t do much about tax avoidance through splitting profits, it can limit tax relief for partnership losses. Special rules limit income tax loss relief for partners who are not active or have limited input into the business. 

 

In what circumstances can HMRC attack a tax-saving partnership?

HMRC’s generally relaxed attitude to partnerships is tempered by the so-called “settlements legislation”. It allows HMRC to block tax savings by treating the profits allocated by the partnership to a spouse/civil partner not active in the business as taxable on the other spouse/civil partner. This type of attack is simple to rebuff as the settlements legislation can only apply if the inactive partner is only entitled to income, i.e. a share of the profits, but not a share in the partnership’s capital assets, e.g. goodwill etc.

A partnership agreement which sets out each partner’s entitlement to income and capital will be enough to defeat HMRC’s attack under the settlements legislation.

 

COMPANIES

Does a company have to pay the national minimum/living wage to the spouse/civil partner?

Before answering this question it’s worth recapping on why a trader might want to pay the spouse/civil partner less than the minimum wage. The reason is simply that a lower salary might produce a more tax-efficient result. The principles involved are the same as those for a sole trader business, although the tax consequences are more convoluted for a company owned by one spouse/civil partner paying the other, compared to a sole trader.

The exemption from the minimum wage regulations for family members cannot apply to a company because a company has no family. Therefore, the minimum/living wage must be paid to all employees except where they are not entitled to it for another reason.

However, individuals are excluded from minimum wage entitlement in respect of fees they are paid for being a director. This allows greater flexibility for tax planning where the spouse/civil partner concerned has income from a directorship and from elsewhere as it allows them to be paid at a rate below the minimum wage if that’s more tax efficient than paying them more.

 

How does paying the spouse/civil partner from a company save tax?

The company’s taxable profit is reduced where it pays the spouse/civil partner. This reduces its corporation tax (CT). It also reduces the amount of profit the original shareholder can take from the company but can save tax and NI where the spouse/civil partner would pay less than if they took the income. 

 

Can a director shareholder transfer some shares to the spouse/civil partner to improve tax efficiency?

Taking profit from a company as dividends can be more tax efficient than taking it as salary. It follows that splitting income by having the company pay dividends to a spouse/civil partner can increase tax and NI savings.

A company can only pay dividends if it has profits (after CT has been paid) which it hasn’t already paid out (distributed), typically as dividends. It can pay salaries or provide benefits in kind even if it is loss making.

 

Can the company pay different rates of dividend to the spouse/civil partner?

Yes, it can be done but there are several tax traps to watch out for.

There are two ways to pay different dividends to each spouse/civil partner:

• one shareholder waives their entitlement to the dividend; or
• the shareholders own different classes of share (often referred to as alphabet shares).

 

What are the pros and cons of dividend waivers?

When a company pays a dividend, every shareholder receives payment in proportion to their shareholding. Shareholders liable to higher rate tax will have more to pay than those liable at the lower rates. This allows for some tax planning.

A dividend waiver involves a shareholder giving up their entitlement to a dividend before it arises. A waiver can therefore avoid the higher rate tax bill that would be payable on a dividend.

Example

Nick and his wife Sally each own one share in Ccom Ltd - the company has only ever issued two shares. It can afford to pay a dividend of £20,000. Nick already takes a salary from another company which is sufficient to put him in the higher rate bracket of income tax and Sally is unemployed (although she does have profits from rental income of about £5,200 p.a.). Nick will pay £3,375 in income tax on his share of the dividend (£10,000 x 33.75%) while Sally would pay tax at a combination of 0% and 8.75%.

 If the dividend of £20,000 is voted but Nick waives his right to his share of it, his £10,000 stays in the company. Sally’s £10,000 still goes to her and she has tax to pay on this at 8.75% on £8,000, i.e., £10,000 less the £2,000 zero rate band for dividends, as her total income is within the basic rate tax band of £37,700 (for 2022/23).

Ccom Ltd has £10,000 more profit which it can pay in dividends later and Nick has avoided the higher rate tax of £3,375.

The directors must ensure the waiver in place before the right to the dividend arises or it isn’t effective for tax purposes. A final dividend becomes payable once it’s approved in the general meeting, so the deed must be in place before then. Interim dividends must be waived before they are paid. Because the waiver is in effect a gift, to be valid it must be in the format of a deed.

While HMRC can’t challenge a waiver if it’s done properly, it can argue that it constitutes a settlement (gift) for income tax purposes to the other shareholders. Where a shareholder waives a dividend and their spouse/civil partner, who is also a shareholder, doesn’t, anti-avoidance rules treat some of the dividend received by the second spouse as taxable on the first. This might nullify any tax saving that the waiver intended to achieve.

The settlements legislation is an anti-avoidance measure. The rules can apply to a gift between connected persons, e.g. an individual to their spouse/civil partner, where it results in an overall reduction of tax liability. However, a gift from one spouse/civil partner to the other is not caught by the settlement rules if it’s not a gift on income only. That means they won’t apply to income produced by an asset given to a spouse/civil partner but can apply if they are only given the income from the asset.

HMRC takes the view that this is present if a dividend waiver enables one or more of the shareholders to receive a larger dividend than would have been possible if no dividend waiver had taken place. This can be avoided by making sure the dividend declared per share times the number of shares in issue does not exceed the amount of the company’s distributable reserves.

Dividend waivers are fine as one-offs, but a better solution is to issue a different class of shares to each shareholder when the company is formed. That way if the company needs to pay different dividend rates it can do so with less chance of the arrangement being attacked by HMRC.

 

What are the pros and cons of creating different classes of share?

While dividend waivers are frequently used to avoid all or part of the declared dividends going to non-passive or non-working shareholders, they can be risky from a tax planning point of view. A more robust alternative is to subdivide the company’s ordinary share capital into two (or more) classes of share. This means the can declare different rates of dividend for each class of shares, or dividends to one class of share but not the others. 

Example

Dcom Ltd has 100 ordinary £1 shares in issue, 50 owned by Penny, 50 by Sheldon. Dcom has enough profit to pay a dividend of £10,000 (£100 per share).

As all the shares are of the same class, Penny would receive £5,000 and Sheldon £50,000. But they agree that Penny should receive more of the profits because she works full time in the business. Rather than Sheldon waiving some or all his dividends he and Penny took the following steps:

Step 1. They held a general meeting and agreed to reclassify the share capital so that now Penny had 50 “A” ordinary shares and Sheldon 50 “B” ordinary shares.

Step 2. Dcom declared a dividend of £150 per “A” share and £50 per “B” share, so Penny received £7,500, Sheldon £2,500 (a total of £10,000).

For companies where one spouse owns all the shares and wants to split their dividend income with their spouse/civil partner:

• the company can issue a new class of ordinary share to the spouse/civil partner
• the share-owning spouse/civil partner can give some of their shares to the other (if the company has only issued one share or an awkward number, they can be subdivided, e.g. one £1 share can be subdivided into say, 100 1p shares. Subdivision of shares is a relatively simple process. More information about subdivision and the forms required is available from Companies House https://tinyurl.com/my8aktw9.

The gift or issue of new shares where the only two parties involved are married or in a civil partnership does not create any capital gains tax (CGT) or inheritance tax issues. A gift or new issue of shares is exempt for stamp duty.

To prevent the settlement rules applying, the shares issued by the company or given by one spouse/civil partner to the other, must be ordinary shares not income only shares.

HMRC might attack an alphabet share arrangement if a company did not have enough profits to pay the same rate of dividend to both spouses/civil partners. In other words, the same rate doesn’t have to be paid but there must be sufficient profits to do so hypothetically.

If the company has shareholders other than one individual and their spouse/civil partner, the issue of new shares (except very soon after the company is formed) can raise CGT issues, therefore, a gift of shares by one spouse/civil partner is usually the best option.