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It is common practice in SMEs for family members to provide services to the business and be paid a salary for doing so.
In many cases, it is not a coincidence that such family members are in a lower tax bracket than the proprietor. Typically, a spouse will be paid a salary, often equal to or close to the annual tax allowances, for performing ancillary and often relatively “low level” tasks for the company. For example, filing of documents (both hard and soft copies), telephone duties, cleaning, social media services, research etc. In these cases, this may be viewed as a tax-efficient profit extraction tool, whereby the spouse pays less tax on the salary than the proprietor would have if they were remunerated for carrying out the duties.
To justify the tax-deductibility of the payment in the company, it is necessary to show that: the services were really performed; that they are wholly and exclusively for the purposes of the company’s trade; that proper records are kept in relation to the services provided, and that the salary level is appropriate for the related services. If these conditions are not fulfilled, the expense will be disallowed for corporation tax purposes, whilst possibly still taxed in the spouses’ hands. This would of course be the ultimate tax inefficiency.
There are other related considerations regarding payment of a spouse’s salary:
- Keeping a simple diary, and ideally time sheets as if they were a fee-earner, will prove to HMRC that the spouse was legitimately earning their salary. Even better are, for example, mileage expense claims for those trips to the bank and post office that are required for the spouse to fulfil their “office manager” role.
- If the company is not already registered as an employer with HMRC then the proprietor must register it and operate PAYE and NIC on their spouse’s earnings.
- If the spouse is not a director of the company, and does not have a contract of employment, then they must be paid at least the National Minimum Wage.
Many proprietors legitimately issue shares in their company to their spouse, although this must be done with due care and attention due to the issue of commerciality. This is useful for the following reasons:
- If the spouse holds a minimum of 5% of the shares, they may qualify for Entrepreneurs Relief (ER) on closing or selling the company. ER is a special rate of Capital Gains Tax of 10% of the gain on disposal.
- For ER purposes, the shareholder must be either an officer or employee of that company. Providing salaried services for the company will help to substantiate this.
- On a sale or closure, the spouse will be able to use their annual CGT exemption of, currently, £12,000. So, both the proprietor and spouse then qualify for an annual exemption each.
- A shareholding spouse can receive dividends which are generally taxed at favourable rates.
A recent case in point was that of Stuart Forsyth, the former CEO of a small insurance company. Whilst in this instance he was not the proprietor of the business, he fell foul of possibly diverting part of his salary to his wife, thereby saving an alleged £18,000 in tax, over six years.
To summarise the case:
- Before 2010, Mrs Forsyth received £5,000 - £10,000 per annum for completing administrative work, which was an appropriate salary.
- Between 2010 and 2016, Mr Forsyth transferred an increasing amount of his salary to his wife and either all or part of his bonus to reduce his tax liability.
- Within these six years, Mr Forsyth transferred over £200,000 to his wife and avoided paying £18,000 worth of income tax.
- Although the company’s Board and Remuneration Committee were aware that Mr Forsyth paid his wife a portion of his salary, they were not aware of how much. By the 2015/16 tax year, Mrs Forsyth’s remuneration was over £52,000 – higher than any other employee’s salary (excluding Mr Forsyth).
- Mr & Mrs Forsyth concealed the amount of remuneration and created false minutes to create the impression that the Remuneration Committee had agreed to both salaries. However, the committee had only agreed on Mr Forsyth’s pay.
- “Mr Forsyth inappropriately involved himself in a subsequent investigation by an external auditor” and provided the Prudential Regulation Authority (PRA) with the aforementioned false minutes, when sent an information request.
- A press release from the Financial Conduct Authority (FCA) stated that “By deliberately arranging these payments to Mrs Forsyth, Mr Forsyth acted without integrity to his financial benefit.”
- Specific to this case, Mr Forsyth’s falsified minutes elevated the case from tax evasion to fraud. The FCA and PRA decided to ban Mr Forsyth from operating within the financial services industry. A final decision has yet to be made.
For more information on best practice for tax efficient profit extraction, contact our Tax team at Tax_Cornhill@geraldedelman.com