I have recently started my own consultancy business within a limited-liability company structure. I want to be as tax-efficient as possible and, as my wife earns only £7,000 a year from her part-time job, I had considered paying her a salary to utilise some, if not all, of her basic-rate tax band.
However, a friend has suggested that giving my wife half the company shares so that dividends can be paid to her would be more tax-efficient. Is this correct?
In theory, the answer is yes but in practice the answer is definitely no and great caution needs to be exercised.
I will assume for the purpose of the comparison that the company's pre-tax profits without a distribution to your wife will be £100,000 and so will be subject to 19 per cent corporation tax. Now let us assume that you pay your wife a salary of £28,000 to utilise her basic-rate tax band. After taking into account all tax and National Insurance implications, your wife would end up with £19,269 and the company's after-tax retained profits would be £55,417.
Now let us assume instead that rather than paying salary, you declare dividends which result in your wife receiving a gross dividend of £28,000. Your wife would receive a net payment of £25,200 with no further tax to pay and the company's after-tax retained profits would be £55,800.
So the dividend route in this scenario is obviously much more tax-efficient, resulting in more money for the individual at less net cost to the company. However, there is a potentially serious flaw.
Until recently, the practice of one spouse owning shares in the other spouse's business for the purpose of dividend income was the accepted norm. However, there have recently been significant attacks by the Inland Revenue on such methods of remuneration. Tax-efficiency now depends on the type of business, its assets, the business risk to which any original capital is exposed, the source of this capital, the part each spouse plays in the business and the income payable to each spouse.
Given that you have stated that the business will be a consultancy, I think it is fair to assume that at outset it will not require significant capital or assets and that you will be the main fee earner. If this is the case and your wife will play little or no part in the generation of profits, then the Inland Revenue is now likely to challenge the settlement of shares from you to your wife. with the result that her dividends will be taxable on you.
The challenge will come with reference to section 660 of the Income and Corporation Taxes Act 1988. As the name suggests, this act has been around for some time but it is only very recently that section 660 has been used against family companies.
Sections 660A and 660B deem income arising in a settlement for the benefit of a spouse of the settlor to be taxed as if it remained the income of the settlor. This is not new. What is new is the extension of the Inland Revenue's meaning of the term “settlement”. In section 660G, it is defined as to include “any disposition, trust, covenant, agreement, arrangement or transfer of assets”.
While the section specifically excludes “an outright gift by one spouse to the other of property from which income arises”, this is “unless the property given is wholly or substantially a right to income”.
If, as I suspect will be the case, the majority of the company's profits will be attributable to you and you will not be paid a salary which closely matches these profits, then the settlement of shares to your wife is likely to be held to be a settlement substantially of a right to income.
As such, the Inland Revenue may at some time demand that all the higher-rate tax saved by the exercise is paid by you, together with interest. The challenge may not come for some time but could be backdated by as many as six years.
So the dividend route is seriously flawed but do not think for a minute that this means that the salary option is the right one. If you pay your wife a salary of £28,000 a year, you could face an alternative challenge from the Inland Revenue unless this level of salary is commercially justifiable for the contribution she makes to the business.
I am afraid there is no straightforward answer and great care needs to be taken in any tax-mitigation exercise. Good luck with your business.