Paying dividends to spouses – how to avoid the tax traps
Many companies pay dividends to spouses, but what are the tax traps to avoid and how can spouses benefit from splitting company shares? Brona MacDougall advises.
It is very common for one-person companies to utilise their directors’ tax-free allowance by paying themselves a small salary. With proper planning, the director incurs no income tax or National Insurance contributions (NIC’s), while the company receives corporation tax relief.
Directors can duplicate this process with a non-earning spouse, gaining tax relief on two salaries. But for the spouse’s salary to qualify as a company expense, they must take an active role in the business and cannot receive a wage purely for their marital relationship; otherwise, the tax relief could be invalidated.
However, by transferring company shares, both partners can withdraw excess profit as dividends, enjoying lower tax rates without incurring NICs. Importantly, shareholders are not required to perform company duties to earn dividends.
However, anti-avoidance rules provide that if a spouse’s income arises from a ‘settlement’, it is deemed to be the income of the other spouse. If one spouse receives income for activities carried out by the other, this rule applies.
It does not apply for:
Unmarried, cohabiting couples or married couples where the income arises from an ‘outright gift’ (i.e. not subject to conditions, or reclaimable).
There are two additional conditions for the exception to apply:
1. The gift ‘must carry a right to the whole of the income’; and
2. The gift ‘is not wholly or substantially a right to income’.
EXAMPLE CASE: Garnett v Jones
Mr Jones purchased a new company, subscribing for the shares 50/50 with this wife. While Mr Jones carried out consultancy work, Mrs Jones handled minor administrative tasks. Both received low salaries and high dividends. HMRC argued that the income constituted a settlement, being taxable on Mr Jones. He argued that the transfer of shares was an outright gift, and was thus exempt from the settlements legislation.
Mr Jones ultimately won his case at the House of Lords; although the gifting of shares represented a settlement, the exception applied as the shares were ordinary shares, constituting a bundle of rights, including rights to capital in a winding up and rights to vote – and as such were an ‘outright gift’ and not merely a gift of income.
Companies may distribute ‘alphabet’ shares, which restrict shareholders’ voting rights, and/or their right of income to dividends or capital on winding-up. Gifting such shares could be argued to be substantially a right to income and therefore may not meet the criteria for the exceptions.
If one spouse receives a variable second income, a 50:50 split is no longer tax-efficient, and adjusting their shareholding is an inadequate solution. Theoretically, dividends could be waived to allow the other to withdraw more dividends.
A deed of waiver must be properly executed, signed by the shareholder and witnessed, before being returned to the company. The waiver must be in place before the dividend is paid. Proper planning is advised, as HMRC may challenge any waiver that is not made for a real business benefit.
Share splits are most tax-efficient when one spouse is non-earning, but if you and your partner have multiple income streams, strategising can become more complicated and it is recommended that you consult an experienced tax adviser.