In this excerpt from the report 'Tax Tips for Company Directors', Jennifer Adams gives some tips on how to pay a salary to a family member.
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One of the most efficient methods of reducing a company’s tax bill and increasing the amount of cash withdrawn at the same time is by paying a salary to a member of the directors’ family. Such members can be the director’s spouse /civil partner or children at university for example.
There are other non-tax reasons for employing a spouse or civil partner including that an employee is given NIC credit towards their state pension entitlement and an employee’s salary will always count as ‘relevant earnings’ to enable private pension contributions.
Tax trap - ‘Settlements legislation’
Care needs to be taken in order that the payments do not fall foul of what are termed the ‘settlement’ rules’. The question here is whether by allowing the family member income from the business he or she is actually earning a PAYE salary or whether the owner-director has created a settlement and ‘retained an interest’ in the business.
The ‘settlements legislation’ is a piece of tax legislation available to HMRC to counter income being diverted from directors to family members who pay tax at a lower marginal rate than the director (termed ‘income splitting’).
‘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’, therefore, a ‘settlement’ could apply in any non-trust situation.
Should an individual create a ‘settlement’ but retain ‘an interest’, then under this legislation 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’ family member can benefit. On its own, this section would prevent tax saving by the making of gifts of income-producing assets to family members paying lower rates of tax. However, an ‘outright gift’ is not caught under these rules provided that the gift carries a right to the whole income and is not ‘wholly or substantially a right to income’.
In the past HMRC have investigated a number of arrangements made under the ‘settlement’ rules with particular reference to situations whereby the spouse was also a director who owned shares in the company but received substantial dividends that would not be the allocation in comparison with another shareholder with the same number of shares. In the end only four cases have reached the Courts with HMRC winning three and partially winning the fourth which was the now infamous ‘Arctic Systems’ case (Jones v Garnett 2007 UKHL 35). HMRC won the ‘settlement argument’ but 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, so 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 does not apply.
Although the ‘settlement’ rules remain available for use by HMRC the last case brought is now over 10 years old, HMRC having decided that they have other priorities.
How much to pay
In order to qualify as a deduction against the company’s tax on its profits, the family member needs to be ‘really’ earning the amount that is paid to them. The amount paid must be in return for the work they undertake. If no work or little work is undertaken then HMRC could refuse the company a tax deduction and treat the payment as a distribution to the director. Paying a spouse or civil partner say, £50,000 a year for one days’ work a week might possibly be challenged by HMRC and if upheld would result in the expense being disallowed as not being incurred ‘wholly and exclusively’. The salary must be reasonable for the work undertaken - salary greater than would be paid to another non family member to do the work could be investigated by HMRC. By appointing the family member as a director a small salary could be paid, even if the actual work undertaken is little.
Note: the considerations as to the amount of salary to pay are the same as when calculating the ‘optimal’ salary (see section 2.5) ‘optimal’ salary amount), namely that although NIC is not payable by the employee on £9,568, the employer is liable for NIC of an amount in excess of £8,840 (i.e. £100.46). However, as corporation tax relief is available at 19% on the whole amount of salary plus employer’s NIC then the corporation tax deduction outweighs the amount of NIC due such that for 2021/22 the ‘optimal salary’ is £9,586 in the situation where EA is not available but £12,750 where it is.
- Paying the ‘optimal’ salary amount of £9,568 also means that the family member has a year’s NIC contributions towards their state pension without having to pay any employer’s NIC, although this could also be achieved if a salary of the Lower Earnings limit of £120 per week is taken.
- The salary should be paid into the family member’s personal bank account and be recorded in the accounts as payment to another employee; the company will also need to comply with the Real Time Information requirements of a payroll scheme.
- Should the family member also be a shareholder there will also be the option of withdrawing more from the company if needs be.