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Two&#39s company

There can&#39t be many of you out there who don&#39t have the owner/managers of private limited companies as clients. Often, these will include shareholders who are married couples. In some cases, both will be full-time directors as well as shareholders of the business and will spend all their time in the business. In other cases, while one of the couple will spend all their time in the business, the other will not, even though they own a significant shareholding.

The reasons for this latter set of circumstances are very often income tax-related. Since the introduction of independent taxation in 1990, as well as having her own personal allowance – the amount that can be earned tax-free in any year – the wife will have her income assessed on her and not on her husband.

Ensuring that income generated by the business is split among the two as opposed to be being paid wholly to one will mean that the overall tax burden will be reduced.

Of course, it is not necessary to be a shareholder in a company to receive income from it. Many spouses of the main contributor to a business, incorporated or otherwise, will be employed and will receive a salary. Paying up to at least the income tax and National Insurance threshold is considered by many as a de rigeur (pretentious? moi?) piece of tax planning.

However, even in connection with this seemingly innocuous piece of tax saving, it is worth bearing in mind that not only must the salary actually be paid and all the normal formalities associated with employing a person complied with but also, to be deductible for the paying business, the salary must be capable of being justified as having been paid wholly and exclusively for the purposes of the trade.

Broadly speaking, this means that the amount paid must be justified as being reasonable in return for the work carried out. At the level of the personal allowance, this should not cause a major problem for most businesses. But what if you want to pay more? Well, that is OK provided you can justify the payment as wholly and exclusively for the purposes of the trade. This becomes more demanding as the amount paid increases.

It is not hard to understand the reasons why it might be desirable to pay sums greater than the personal allowance. While a tax-free payment is most attractive, it makes good sense to have income taxed at 10 per cent or even the basic rate as opposed to 40 per cent if the amount in question were paid to a high earner.

The greater the amount paid, though, the greater difficulty in justifying the payment. Where this difficulty is anticipated, many will have considered other methods of ensuring income ends up in the ownership of a taxpayer who pays a lower rate of tax. It does not take much thought for those trading through a company to consider payment by way of dividend.

This will be taxed on the shareholder regardless of the level of work carried out and the wholly and exclusively test is not applied. Of course, you need to be a shareholder to receive dividends and here lies a primary reason for many husband/wife shareholdings.

Once the intended recipient of funds from the company is a shareholder, the dividend can be paid and taxed on the recipient. If the recipient is a 10 per cent or basic-rate taxpayer and the dividend does not take them over the higher-rate tax threshold (the dividend having been grossed up to take account of the 10 per cent tax credit, usually effected by dividing the dividend by a factor of 0.9) no further tax is payable. If the shareholder is a non-taxpayer, no tax will be payable but the tax credit cannot be reclaimed.

To the extent that the grossed-up dividend exceeds the higher-rate tax threshold, then the grossed-up dividend will be taxed at 32.5 per cent and the tax credit deducted to leave an additional tax liability equivalent to 25 per cent of the net dividend payable. This will need to be paid by January 31 in the tax year following that in which the dividend is paid.

Not only does the dividend avoid the need to satisfy the wholly and exclusively test but it also (most importantly and even more so from April 6 this year when the new NI rates bite) avoids both employer and employee National Insurance. By definition, the dividend is not tax-deductible as it is a payment made out of after-tax profits. But, in the overall scheme of things, the leakage of money to the authorities will be lower except where, broadly speaking:

•The recipient is a non-taxpayer. In this case, the payment of salary will be more tax-effective as no NI will be payable, provided the payment is deductible under the wholly and exclusively test.

•The company&#39s tax rate is other than the small companies&#39 rate and the recipient is a higher-rate taxpayer.

Having said all that, it appears that there are reports of increasing Inland Revenue action to attempt to prevent the tax-effectiveness of dividends paid to shareholding spouses (usually wives) who, in the Revenue&#39s view, carry out comparatively little work for the company.


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