When a limited company is formed a new entity is created. Legally, this entity is separate from all other individuals, including the owners (shareholders) who may or may not be the same people as those who manage the company (directors).
It is invariably the case that a sole trader or partnership commences in business and the business grows such that the matter of incorporation needs to be considered. Although the decision to incorporate should be for commercial reasons rather than tax savings, any tax savings that may result needs to be factored into the decision.
As a company director, there are a number of tax challenges, including how to extract profits from the company in a way that is efficient from both a tax and National Insurance perspective.
The following is an extract from our best-selling report Tax Tips for Company Directors. Get the full report here.
Paying A Salary To A Spouse
How it works
One of the most efficient methods of reducing a company's tax bill and increasing the amount of cash withdrawn at the same time is by paying a salary to the director’s spouse. However, care is needed in order that the payments do not fall foul of what are termed the 'settlement’ rules'. The question here is whether by allowing a spouse (or civil partner) income from the business she/he is actually earning a PAYE salary, or whether the owner-director has created a settlement and ‘retained an interest’ in the business (s624 ITTOIA 2005).
Tax Trap - 'Settlements Legislation'
The 'Settlements' Legislation' is a piece of tax legislation which is increasingly being used by HMRC to counter income being diverted from directors to family members who pay tax at a lower marginal rate than the director themselves (termed 'income splitting').
On first reading, this Legislation would appear to have nothing to do with the withdrawal of monies from a company in a business situation. 'Settlement' is usually a term used in relation to the creation of a trust. However, in tax law the same word has a much wider meaning being ‘any disposition, trust, covenant, agreement, arrangement or transfer of assets’ (s620 (1) ITTOIA 2005), therefore, a 'settlement' could apply in any non-trust situation.
Should an individual create a 'settlement' but retain ‘an interest’, then the income of that settlement is treated as still belonging to the settlor (in this instance the director). ‘Retaining an interest’ includes a situation where the settlors' spouse can benefit. On its own, this section would prevent tax saving by the making of gifts of income-producing assets to spouses paying lower rates of tax. However, an ‘outright gift’ between spouses (as permitted via s 624 ITTOIA 2005) is not caught providing the gift carries a right to the whole income and is not ‘wholly or substantially a right to income’. Should the settlor (director) retain an interest in the property or income then all of the income will be treated as belonging to him and the reduction in tax that was trying to be achieved would not be possible. The spouse must receive whole rights, meaning the right to dividends, voting, and capital on sale or winding up of the company.
Tax cases brought to court so far under the 'settlement' rules have concentrated on the arrangement whereby the spouse is also a director who owns shares in the company but receives substantial dividends that would not be the allocation in comparison with another shareholder with the same number of dividends. HMRC have challenged thousands of companies under the 'settlement' rules, but only four cases have reached the Courts - HMRC winning three and partially winning the fourth.
Other Methods Of Withdrawing Monies
This last case was the now infamous 'Arctic Systems' case where HMRC won the 'settlement argument' but actually lost the case due to the judge's ruling that although the shareholding arrangements constituted a 'settlement', they were exempted under the outright gifts clause spouse to spouse. Therefore, as long as a spouse is given ordinary shares in a company (carrying the normal full range of rights) then any dividends paid on the shares are treated as their income and the settlements legislation would not apply.
After the final hearing, HMRC issued a statement indicating that they would amend the legislation but nothing has been published to date so the ruling stands.
How Much To Pay
If the payment remains under the employers' NIC Primary Earnings Threshold for employees and the Secondary Earnings Threshold NIC Limit for companies (both Thresholds being £8,424 for 2018/19), then no NIC is due for either the employee or employer. The company also saves tax 19% of the gross amount (i.e. £1,600 i.e. £8,424 x 19%); the benefit of paying a salary of this amount also means that the spouse has a years' NIC contribution towards the state pension.
- The spouses' salary must be reasonable for the work undertaken, but by appointing the spouse as an officer a small salary could be paid, even if the actual work undertaken is little, if any. Salary greater than would be paid to another to do the work could be investigated by HMRC.
- The salary should be paid into the spouse’s personal bank account and be recorded in the accounts as payment to another employee. The company will need to comply with the Real Time Information requirements of a payroll scheme.
This article was first printed in Tax Insider in November 2018.