Employing a Spouse
Navigating the intricate landscape of self-employment is no easy feat, especially for contractors. Amidst the myriad of regulations, one term stands out prominently: Limited Companies. But how does employing a spouse work?
It is common for contractors to add a spouse as a second shareholder or employ them to help with the company’s day-to-day running. While the process may be relatively straightforward, whether it is the right decision is another matter entirely. It is not the right decision for every married couple, and several vital issues must be considered.
In this comprehensive guide, we delve deep into the heart of limited companies. Whether you’re an aspiring contractor or a seasoned veteran seeking clarity, this guide aims to empower you with the knowledge to make informed decisions.
How To Employ A Spouse
Your spouse can work for you, although you must ensure you run a PAYE scheme. Any income tax and National Insurance owed will be paid via PAYE. The wages you pay your spouse are an allowable expense, meaning they’ll reduce the corporation tax you owe.
It’s also important to note that if you pay your spouse a wage, you should ensure they do some work in the company. If they don’t, their status as an employee could be challenged by HMRC. What counts as sufficient work to satisfy HMRC is highly subjective; however, it could be anything from submitting invoices to opening mail or helping to maintain accounting records.
How Much Can I Pay My Spouse?
If your spouse is not a director of your limited company, and they do not have a specific employment contract, you must pay them at least the National Minimum Wage. If you want to pay your spouse more than the National Minimum Wage, it’s essential to consider the fair market value of their work. The salary should be at a ‘commercial rate’ for the service provided.
Although HMRC does not prescribe a specific wage for individual services, one way to think of this is to consider what you would be willing to pay someone else for doing the same job. If you were to ‘overpay’ your spouse for their work specifically to take advantage of their lower tax rate, it could be classed as ‘income shifting’ and be caught by the Settlements Legislation (more on this below).
The optimum salary to pay your spouse depends on how much they currently earn. If your spouse has made enough to use up their entire personal allowance, there is no benefit in paying them a salary through your limited company.
If your spouse has already used up their personal allowance and you pay them a salary, while you save corporation tax, your spouse will have to pay income tax at 20%, 40%, or even 45%, depending on their tax band.
If your spouse has no other sources of income, then the optimal salary is £1,047.50 per month, this being the Primary Threshold limit. Although you will incur Employer’s National Insurance, these costs will be less than the income tax saved by your spouse.
How Does IR35 Impact This?
If your contract is inside IR35, you are limited to the existing profits (earned from Outside IR35 work) from which to pay your spouse. Any income from an inside IR35 contract is taxed as employment income, so paying your spouse a salary becomes tax-inefficient.
There is no corporation tax against which to offset the costs, and the salary itself would effectively be subject to double taxation. Once for yourself when earned and once when paid to your spouse.
Can I Make My Spouse A Shareholder?
Many contractors split ownership of their limited company with a spouse or partner to take advantage of the lower tax rates associated with dividends instead of income. By making your spouse a shareholder of your limited company, they become entitled to a proportion of any issued dividend.
The proportion of dividends your spouse is entitled to is calculated by the percentage of shares they own. If there are 100 shares in the company, and you both own 50 shares each, you are both entitled to receive 50% of any dividend issued.
For example, if you, as a contractor, earn over the higher rate threshold, any dividends you receive will be taxed at 33.75%. Splitting this dividend with a spouse with no other income would see them pay tax at the basic rate of 8.75%, a difference of 25%.
This is a particularly effective way to reduce taxes paid to HMRC when your partner has little or no income of their own. As with the salary above, if your spouse or partner has other significant income, there is unlikely to be much of a tax saving by making them a shareholder.
What Is The Settlements Legislation And The ‘Spousal Exemption’?
Contractors considering making their spouse a shareholder in their limited company may have come across the ‘Settlements Legislation’, specifically designed to prevent income shifting. Income shifting involves transferring personal income to another individual who pays tax at a lower rate.
HMRC argued that under the Settlements Legislation, a gift of shares from a fee-earning contractor to a non-fee-earning spouse was a ‘bounteous settlement’ and that any income should continue to be taxed as if it were the contractor’s.
Fortunately for contractors, in 2007, the Court of Appeal ruled that the transfer of shares to a spouse is captured under the ‘spousal exemption’, meaning it is outside the remit of the Settlements Legislation. Although the court upheld a contractor’s right to make their spouse a shareholder in their limited company, they did so in tightly defined circumstances.
For the spousal exemption to apply:
- The fee-earning contractor and non-fee-earning spouse must be married or in a civil partnership and living together;
- The spouse must play an active role as a shareholder; they cannot simply sit back and accept the dividends; and
- The shares must be an outright gift with the same rights as the original ordinary shares. They must have full voting rights and no promise to return them.
If any of the above criteria are unmet, HMRC may take interest, and the spousal exemption may not apply.
What If We're Not Married?
If you’re married or in a civil partnership and living with your spouse, you can transfer shares in your company to them without incurring any capital gains tax. They will still have to pay income tax on any dividends received.
If you’re not legally married or in a civil relationship with your partner, transferring part-ownership of your limited company to them will likely incur additional tax liabilities. The spousal exemption will not apply; HMRC could see the transfer as one of value and could seek to charge capital gains tax.
What Are 'Alphabet Shares'?
When a business pays a dividend, all shareholders receive payment proportionately to their holdings. If you hold 25% of the shares, you receive 25% of the dividend. For one group of shareholders to be paid at a different rate or receive preference over another, the company must have distinct classes of shares with unique rights. This is where alphabet shares come in.
The term ‘alphabet shares’ describes different classes of ordinary shares in a company, often called class A shares, class B shares, class C shares, etc. Each type of share can offer a different entitlement to any dividends paid. For example, class A shares may be paid at a greater rate than class B shares.
Alphabet shares are not restricted to being used solely for controlling the level of dividends paid; they may be used to provide entitlement to rules separate from ordinary shares – for example, the limited voting rights at general meetings.
That said, their primary use is to provide a platform through which a dividend can be paid to a particular class of shares without being required to pay the same dividend to each shareholder. This is particularly beneficial when one shareholder is a higher rate or additional rate taxpayer, and the other pays a basic rate or none.
Alphabet shares are a legitimate method many companies use to differentiate between different types of shares, keeping shareholding and dividend distribution clear amongst shareholders. It is also a method contractors can use to ensure they make the best possible use of the tax allowances granted to them and their spouse.
Example: If Jack, a higher rate taxpayer, wants to divert some of his dividend income in his limited company to his wife Anne, who currently has no earnings, he could do this by gifting her some shares in his company.
If Jack does this with the same class of shares he currently owns, Anne would be entitled to a dividend every time one is declared. The trouble with this is that if Anne were to start earning her own income, adding dividends may push her into the higher rate tax band, defeating the purpose of diverting the income.
The solution is for Jack to issue a new class of shares to Anne, called ‘ordinary A shares’. This new class of shares will have identical rights to Jack’s shares, but it will allow the limited company to pay varying rates of dividend at different times.
If Anne starts earning her own income and it no longer makes sense for her to receive a dividend, the limited company can stop paying one to her class of shares while continuing to pay it to Jack.
The issue with the above is that HMRC are very savvy regarding tax avoidance. They may claim that if the level of dividend paid on one class of shares could not have been delivered without no or minimal dividends paid on the other classes, the spousal exemption no longer applies, and the transfer of shares falls within the Settlement Legislation.
Continuing the above example, if Jack owns 75 ordinary shares while Anne owns 25 ordinary A shares, Jack needs to ensure there is enough profit in the company to pay the same dividend rate on Anne’s shares as his own.
If Jack earns £100,000 in profit, the most he can pay himself is £75,000. Anne could not be paid the same dividend rate on her shares if he took more than this, as it would exceed the available profit.
As you can see, alphabet shares can be confusing, and we recommend speaking to a specialist accountant if you wish to pursue this.
What Are 'Dividend Waivers'?
Dividend waivers are where all shareholders have the same type of shares, but one shareholder waives their right to the dividend. HMRC are incredibly suspicious of dividend waivers and frequently challenges them if they think they’ve been made to avoid tax instead of genuine commercial benefit.
Although this is a potential option for contractors looking to make their spouse part of their limited company, it should be approached with caution. There need to be legal documents that are witnessed, and the waiver must be in place before the dividend is paid.
As with alphabet shares, we recommend speaking to a specialist before you make a decision.
What If We Get Divorced?
Although it’s unpleasant to discuss, one of the primary considerations around gifting shares to a spouse is what happens in the case of separation or divorce.
To use the spousal exemption, any shares transferred to a spouse must be an outright gift. They belong entirely to your spouse and cannot be taken back. If you separate, your spouse will continue to own shares in your company and be entitled to any future dividend payments.
One way to protect against the above is with robust Articles of Association and Shareholders Agreement. Such documents can require shares previously transferred to a spouse to be ‘bought back’ by the business in case of a divorce.