Transferring Income to a
Spouse to Save Tax
Business Owners: Transfer Income to Save Tax
TRANSFERRING PART of your income to your spouse or partner can save up to £10,314 a year in Income Tax at current rates. Next year, it could save you over £23,000.
Sadly, not everyone has the freedom to ‘transfer’ their income easily, but most business owners do have some scope to effectively transfer part of their own income to their spouse or partner. Furthermore, most of this type of planning works whether you’re married or not. For the rest of this article, I will therefore just refer to ‘partners’ to cover husbands, wives, civil partners and unmarried partners alike.
If your partner works in your business, you can pay them a salary. In fact, under the national minimum wage, you generally have to pay them at least £5.73 an hour anyway.
Many business owners’ partners contribute to the business on a part-time basis, even when they have a job of their own. The partner might help with the paperwork, take business telephone calls, clean overalls or other workwear, help with purchasing supplies, organise travel arrangements, or carry out any number of tasks associated with the business. Any of these tasks will justify a salary payment (except for entertaining customers, which Revenue and Customs doesn’t generally accept as ‘work’).
A salary of up to £5,715 can usually be paid in the current 2009/10 tax year without incurring any PAYE or National Insurance costs. At current rates, this can save a sole trader or partnership up to £2,343 in tax and National Insurance.
In fact, many sole traders and partnerships are already into accounting periods which will end after 5th April 2010. This means that the business profits will fall into the 2010/11 tax year when business owners will be subject to the new 50% ‘super tax’ on income over £150,000 and to the withdrawal of their personal allowances when their income is over £100,000.
Taking National Insurance into account, profits falling into 2010/11 will be subject to a total effective tax rate of 61% where the owner’s income lies between £100,000 and around £114,000, or 51% where it exceeds £150,000.
This significantly increases the potential tax savings available. A tax-free salary of £5,715 paid to your partner now could save you up to £3,486 next year.
Company owners paying salary to a partner will also save tax. A payment of £5,715 could save up to £1,700 in Corporation Tax or £3,075 in Income Tax and National Insurance if it substitutes for part of the owner’s own salary.
There are a few flies to watch out for in this ointment, however.
The most important point is that you can only get a deduction from your business profits in respect of your partner’s salary if the payment to them is justified by the work that they do. Furthermore, you must actually pay the salary to your partner. There is no automatic deduction just for having a partner. (Even if some might argue that there should be!)
If a payment of £5,715 isn’t justified, a smaller payment should be made instead. Even a salary of just £2,000 could save you up to £1,220.
You will generally need to pay National Insurance on any salary payments in excess of £476 per month (or £110 per week). Any salary should therefore be paid on a regular basis and not in one lump sum.
If your partner is a director in your company, however, you can pay them in a single lump sum if you wish, as National Insurance is calculated on an annual basis for company directors.
You need to treat your partner like any other employee, which means that you will have to apply any PAYE code issued by Revenue and Customs. If they have other employment income, you will probably have to deduct basic rate Income Tax from their salary. This reduces the overall saving but will still be worthwhile in most cases, as we will see below.
Some people feel that formally operating the PAYE system for a partner whose total income does not exceed the £5,715 National Insurance threshold is a piece of pointless red tape, but it has its benefits. Any payment to a partner in excess of £95 per week will enhance their state pension entitlement - but only if you observe all the PAYE formalities. Plus, it’s a legal requirement anyway.
When Does a Partner’s Salary Save Tax?
The best savings naturally arise when the partner has no other income.
If the partner is a basic rate taxpayer, the saving will be smaller but still worthwhile. It now becomes a case of comparing the business owner’s marginal tax rate with their partner’s. Remember that a sole trader or business partner will be paying National Insurance on their profits as well as Income Tax, but their employee partner can receive up to £5,715 free from National Insurance regardless of their income level.
A business owner paying higher rate tax will therefore still save a total of between 21% and 41% on a salary of up to £5,715 paid to a basic rate taxpayer partner - that’s a maximum saving of between £1,200 and £2,343. Even a business owner paying basic rate Income Tax can still save 8% National Insurance.
Too Much of a Good Thing?
Once you start to pay your partner more than £5,715, you will start to incur National Insurance costs on the excess: 11% for them as an employee and 12.8% for you as the employer. Surprisingly, however, there are still many cases where further salary payments will save tax overall.
Firstly, where the partner has no other income, a payment equal to their Income Tax personal allowance of £6,475 will usually be worthwhile. Where the partner is over state retirement age, any payment which is covered by their Income Tax personal allowance will also generally be worthwhile. This could be up to £9,640 in some cases.
For company owners, paying extra salary to a partner in substitution for part of your own salary will always be worthwhile whenever you have a higher marginal personal tax rate than them.
For sole traders and business partners paying higher rate Income Tax, any salary payment to a basic rate taxpayer partner will continue to save tax. The saving is fairly marginal in some cases, but it’s a saving nonetheless. Take care not to pay too much, however. If your partner’s salary takes their total income over the higher rate tax threshold (currently £43,875), or reduces your income below it, the salary will actually start to cost you extra tax.
Colin runs a small bakery as a sole trader and expects to make a profit of £60,000 this year. His partner Bonnie has a part-time job as a secretary, earning £10,000, but also helps Colin in the bakery.
Colin pays Bonnie a salary of £14,944. She pays Income Tax at 20% on this plus National Insurance at 11% on the amount over £5,715 – a total of £4,004. Colin also has to pay National Insurance at 12.8% on the amount over £5,715. This amounts to £1,181, bringing the total tax cost of Bonnie’s salary to £5,185.
Bonnie’s salary and the employer’s National Insurance paid by Colin amount to a total of £16,125 which is deductible from Colin’s business profits, saving him tax at 41%, or £6,611. Overall, Bonnie’s salary saves the couple a net sum of £1,426. (The first £5,715 saved them £1,200 and the rest produced a marginal additional saving of £226.)
BUT if Colin paid Bonnie another £1,000, it would cost a total of £438 in Income Tax and National Insurance whilst only saving Colin a further £316 on his own tax bill – an overall net cost of £122, or 12.2% of the additional salary.
As we can see therefore, you can pay too much salary to your partner.
Partners in Partnership
Under the right circumstances, you can save a lot more tax by making your partner at home your partner at work too (i.e. making your life partner your business partner). This has some very important legal implications which should be considered, some (but not all) of which can be resolved by using a Limited Liability Partnership.
This approach can be much more tax efficient because the National Insurance position for a business partner is much better than for an employee. Instead of employee’s National Insurance at 11% and employer’s at 12.8%, your partner will only pay Class 4 at 8% (plus £2.40 a week in Class 2).
For example, if Colin gave Bonnie a one third partnership share, the couple would save a total of £2,429 instead of the maximum saving of £1,426 achieved with a salary.
An even better way to save tax for a small or medium-sized business run by a couple is to use a company, make both partners shareholders and pay each of them dividends. Paying dividends to two people instead of one can save up to an extra £9,872 this year and could save up to more than £23,000 a year from next year onwards.
This type of planning was the subject of the landmark Arctic Systems case which Revenue and Customs lost in 2007. Since then, the Government has threatened us with so-called ‘income shifting’ legislation, although this has already been postponed twice.
We will look at the implications of any possible ‘income shifting’ legislation in a future issue of Business Tax Saver. In the meantime, there is nothing to stop any couple following the tax saving strategies outlined in this article, as long as they are both actively involved in the business.
Savings for High Earners
For those business owners now facing marginal tax rates of 51% or 61% on their business profits, even a salary paid to a higher rate taxpayer partner could save tax.
Ace anticipates making a profit of £110,000 for her accounting period ended 30th June 2010. Her husband Sylvester, who works as an accountant, estimates that this will give her a tax bill of £39,644 next year.
Sylvester has always helped Ace with her business but, as he already has a salary of £50,000 from his main job, the couple could never see any point in Ace paying him another salary.
This year, however, Ace pays Sylvester a salary of £5,715. As he is a higher rate taxpayer, he will have to pay £2,286 in Income Tax but, since his main employment is not connected with Ace’s business, there will be no National Insurance to pay.
Ace’s business profits will be reduced to £104,285 and Sylvester estimates that this will now give her a tax bill of £36,158. She saves £3,486 and the couple are £1,200 better off overall.
Even if Ace’s profits actually turn out to be just outside the 61% marginal rate band (income from £100,000 to around £114,000), Sylvester’s salary will still give them a small National Insurance saving, so there’s usually no harm in trying this technique even if you’re not quite sure where you stand.On the other hand, if you’re more certain about your profit levels, you may want to pay your partner even more. Where your marginal personal tax rate is 51% or 61%, any salary payment to your partner will save tax overall unless and until it takes them into one of these higher marginal rate tax bands themselves.