Within a family-run business it is naturally very common to employ family members. Whilst this does allow for more tax-deductible money to stay within the family, there are issues and potential minefields that you should be aware of. Helen Johnstone advises.
When it comes to employing family members and putting their wages through the books and claiming the tax deduction, providing they are working as genuine employees, and that the expense is wholly and exclusively for business purposes, then this is perfectly acceptable.
Indeed, with relation to limited companies, instead of (or in addition to) paying family members a salary, it is also possible to give them some shares and allow them to take dividends. Everyone has a dividend allowance, they attract no NICs and dividends attract a lower income tax rate. Many family companies do this by creating alphabet shares to allow the flexible payment of dividends. This can be in addition to any salaries so can be done alongside any existing salary planning.
The same thing can also be done with partnerships, with family members being given a profit share. Whilst this doesn’t have the income tax/NIC benefits of dividends, it would spread the income across more members of the family, thus making full use of multiple personal allowances and basic rate bands.
However, bringing family members in with shareholdings or partnership shares should be accompanied by a degree of caution. The settlements legislation, which has been in existence for around a century, is designed to stop people diverting income to another person who pays income tax at a lower rate.
Excessive profit shares and dividends are historically triggers for HMRC enquiries under that legislation; but aside from the settlements legislation, what are the issues with employing a family member or giving them shares to receive future dividends?
HMRC treats family members like any other employee provided that their salary, benefits and pension contributions are paid wholly and exclusively for the purposes of the business, i.e., it must be a genuine market salary for work that is actually done. Only then can the business claim a corresponding tax deduction, any excessive remuneration will be disallowed as this would be deemed a ‘personal’ payment.
In Nicholson v HMRC  a self-employed individual paid his son (who was at university) a £7,400 ‘salary’ for his employment in leafleting and advertising and IT work; however, there was no PAYE scheme, no records of work done and some of the £7,400 consisted of directly paying some of his son’s food bills and other university expenses.
The First-tier Tribunal held that the £7,400 was not exclusively salary. Instead, it was a father helping his son financially. This duality of purpose meant that the father could not deduct these payments as a business expense. If his son had had a proper employment contract, with documented hours worked with a corresponding salary, and thus had been treated like any other employee, there would have been no issue.
Can a parent give a child shares and allow them to have dividends?
The main issue with dividends is the settlements legislation, particularly concerning spouses and minor unmarried children. There are obviously no business tax deductions for dividends (or partnership shares), so it is not the same issue as with salary.
However, with regards to gifting the shares in the first place, if a family member is an employee or officeholder and they receive company shares, whether that be newly issued shares or the gifting of pre-existing ones, an income tax charge may arise under the employment-related securities (ERS) rules. The tax charge would be applied on the difference between the value of the shares and the amount paid for them, if any.
In a family business, where shares are passed from parents to children as part of business succession, ERS is rarely an issue as there is a specific exemption for ‘transfers of shares in the normal course of domestic, family or personal relationships’. If the motivation behind the transfer was unconnected to the child’s employment in the business, there would be no tax charge. If, however, the children received shares alongside other employees, the motivation behind the gift might be questioned.
There is no reason at all why a family member cannot be employed within someone’s business, so long as they are treated the same as any other employee, i.e., paid a market wage for work carried out. If that is the case, HMRC has no grounds to tax the salary or relieve the expense any differently. Shares can be gifted to family members who subsequently receive dividends, provided those shares were gifted to recipients purely as family members and not in their capacity as employees.