Dividend traps for spouses and civil partners

Richard Curtis considers potential problems when dividends are paid to spouses and civil partners. Husbands and wives or those in civil partnerships (included in the term ‘spouses’ in the rest of this article) will often seek to minimise the family’s tax liability by the efficient use of personal allowances and tax bands. One strategy for business owners who operate through a limited company might be to pay dividends to their spouse. While this may seem straightforward, potential tax traps can lead to unexpected liabilities and scrutiny from HM Revenue and Customs (HMRC).

Dividend payments to spouses

Many private companies, especially family-run enterprises, may include family members as employees or directors. They may then be paid a salary, which will reduce the overall income tax and National Insurance contributions (NICs) liabilities that might arise if the full amount were paid only to the business owner. However, salaries, like other tax-deductible expenses, must be incurred ‘wholly and exclusively’ for business purposes.

Payments will fail this test if the spouse or relatives are not performing duties commensurate with the salary paid. This rule does not apply to dividends, and a business owner may therefore gift shares to their spouse, such gifts being exempt from capital gains tax. Dividends can then be declared on the shares and paid to the spouse. However, such a gift could be viewed as a settlement with dividends being treated as the donor’s income. The ‘Arctic Systems’ case (Garnett v Jones [2007] 78 TC 597) set out basic principles to avoid this problem.

The transfer of shares must be an outright gift carrying a right to the whole of the income and not be wholly or substantially a right to income. Generally, shares will include other rights, such as to vote and to a share of capital in a winding up. To make the situation clear, dividends should always be paid into a bank account in the sole name of the shareholder.

Dividend waivers

Dividends will be paid in accordance with the number of shares held. If an individual shareholder does not wish to receive a dividend, they could waive the dividend, but this must be done properly by a deed of waiver and for business reasons.

Further, this must not result in the total payment of dividends to the other shareholders at a rate greater than the company could afford without the waiver. Issuing shares of different classes may be a possible solution, but this would merit professional advice.Remember also that, unlike salaries, dividends can only be paid out of profits.

Check liabilities

Given that a basic rate taxpayer will be charged income tax at 10.75% on dividends compared to 20% (plus Class 1 NICs) on salary, there may be a temptation to pay dividends rather than salary from a family company. However, as mentioned above, dividends can only be paid from profits which will probably have been subject to corporation tax at 19% (or more), leading to an element of double taxation. Conversely, salaries are deductible in arriving at taxable profits. The total potential corporate and personal liabilities payable should be compared when considering whether a salary or dividend is the most tax-efficient route.

Alternatives

When seeking to extract tax-efficient value from a family company, consider alternatives to pure cash payments of salary or dividends. Pension contributions can be paid by the company on behalf of employees, gaining a tax deduction by the company without an immediate liability on the employee. Benefits-in-kind might also be considered, depending on the relief obtained by the company compared to the liability incurred by the employee.

Conclusion

Finally, remember that while a gift of shares to a spouse may yield income tax benefits, do not overlook the potential implications for capital gains and inheritance tax. Will a gift result in an income tax saving, but the loss of valuable reliefs applicable to other taxes? A holistic overview is essential.

Practical tip

Professional advice is recommended when establishing a limited company, allocating and gifting shares or considering a dividend waiver to ensure that the relevant requirements are satisfied. Tax and non-tax implications must be considered.

Disclaimer: The information provided on AccountingFirms.co.uk is for informational purposes only and should not be considered as financial advice. Always consult with a professional accountant to ensure compliance with UK laws and regulations.