Tax Considerations for Family Businesses
Tax Considerations for Family Businesses
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Oxford Economics estimates that there were 4.8 million family businesses in the UK in 2020, which makes up 86% of all private sector businesses. As a family business ourselves, it doesn’t surprise us, and we understand first-hand the benefits that come with turning to family when you need a helping hand with your business. There can be tax advantages when it comes to running a business with your family, but there are also certainly many tax rules. Our comprehensive guide goes over several tax considerations for family businesses and how to make the most of family earnings.
How to structure a family business
There are three main ways you can operate a family business: as a sole trader (employing family members for the business), as a general partnership (when two or more members of the family agree to work together), or as a limited company (when you create a separate legal entity with your family). How you decide to structure your business will largely be down to personal preference, but it may also be influenced by the size, nature, complexity of your business, how flexible you would like to remain when working with your family, and whether you would want limited liability protection.
By far the simplest solution when starting a business is to operate as a sole trader; however, this option presents less tax-saving solutions and cannot offer you the ability for multiple members of the family to have ownership in the business. Partnerships are one way to solve this limitation whilst still being relatively simple and flexible to manage but can cause complications should a breakdown in relationships arise. Finally, limited companies can offer the most tax benefits but by far have significantly more ongoing compliance requirements and is usually more expensive to wind up should you decide to close the family business.
Book an introductory call if you would like advice on how to structure a family business.
The advantages and disadvantages of running a family business
Before considering the various tax implications, we also want to weigh up the advantages and disadvantages of running a family business.
- Sharing family values often means those working in the family business will have a similar idea of how they would like to run it. It’s incredibly powerful when everyone working in a team are well-aligned without ulterior motives or conflicting targets as you’re much better built for success this way.
- Being able to keep wealth within the family household is often considered one of the biggest advantages to running a family business. It means everyone involved benefits, costs are shared, and income generated goes towards shared outgoings like utility bills or holidays.
- Trust and commitment can be more difficult to foster when it comes to general employees but can come much more naturally when employing and working with family members. Turnover of staff disrupts business and recruitment can be expensive so depending on family is a key factor to be seen as an advantage.
- If you’re only working with family members, it may mean that you’re not hiring people with the best skills for the job. This can make growing a business much harder, especially against competitors.
- Family conflicts are inevitable regardless of whether they’re due to personal or professional reasons. This can interfere with the smooth running of a family business, so it’s important that you’re sure you can put differences aside when needed.
- It can be more difficult to decide what to do with a family business when it comes to passing it down or winding it up. It may be that you and your spouse or partner are going through a divorce, or you’d want to continue your business by passing it down to your children who aren’t interested in taking it over. Family relationships can make it more difficult to decide what happens to an asset such as a business.
The tax benefits of adding your spouse or partner as a shareholder in the family business
If you’re running your family business as a limited company, then you’ll be able to add shareholders in the company. The tax benefit to doing this is that shareholders are entitled to dividends if the company is in profit. Whilst you still have to pay tax on any dividends received, it is taxed at a far lower rate than standard income tax which would apply to salaries. What’s more, shareholders are entitled to tax-free dividends allowance each year.
For the tax year 2023/24 the tax-free dividend allowance is £1,000 (this is due to reduce to £500 in 2024/25) and the dividend tax rates are:
- 8.75% for basic rate income taxpayers
- 33.75% for higher rate income taxpayers
- 39.35% for additional rate income taxpayers
Therefore, adding your spouse or partner as a shareholder to the family business means you can extract funds from the limited company and distribute to them at a lower rate of tax. It also means that they will have ownership in the business.
The tax rules of employing your spouse or partner for the family business
For a limited company family business, another way to extract funds from the company to redistribute to the family is to pay salaries. To be able to do this, your spouse or partner must be performing a legitimate function for the business and be compensated for those responsibilities appropriately. Paying your spouse £50,000 per year to do some simple filing is likely to be considered unreasonable, but the salary could be seen as more justifiable if they were a company director with significant responsibilities in the business. The rule on paying your spouse or partner an appropriate wage applies even if your family business is not run as a limited company but run as a sole trader. An important point to note is that where a family member is employed but lives in the same household as the employer then there is no legal obligation to pay them the national minimum wage. This may not be as relevant when employing a spouse or partner but could be more applicable when we discuss employing children for the family business in the sections below.
The tax benefits of employing your spouse or partner for the family business
The tax benefit of paying a salary to your spouse or partner is that you can do this even if your company is not in profits (unlike when issuing dividends). Furthermore, paying a salary is a tax-deductible business expense which means it reduces your corporation tax. Some other considerations to bear in mind are that if you do employ your spouse or partner, you will need to include them on your payroll and make National Insurance (NI) contributions. So long as they are being paid above the NI threshold, you’ll be able to claim Employment Allowance (EA) which will help reduce the company’s NI liability. Your spouse or partner’s salary will count towards their relevant earnings which will enable them to make private pension contributions. Any pension paid as part of a workplace pension scheme is further tax-deductible for the company.
When employing your spouse or partner as a sole trader, there are many similarities to employing them to if you were operating as a limited company. The one disadvantage is that paying them a salary will not reduce any corporation tax (because there is none to pay as a sole trader) but instead reduce your own income tax. This will mean that they will pay income tax on their earnings instead, but be able to utilise their own personal allowance. As with a limited company, you’ll need to run a payroll in order to pay them their salary, along with any NI contributions and workplace pension, and these payments will further reduce your own income tax liability. You’ll also be able to claim EA so long as they are earning above the NI threshold which will reduce your employer’s NI liability. Employing a spouse or partner is beneficial to make use of their personal allowance if they would not be employed otherwise.
The tax rule of adding your children as a shareholder in the family business
Whilst there is no legislation which prevents children from becoming shareholders in a company, there are strict rules on how income from the shares may be taxed. Even children are entitled to a personal allowance, so your first thought may be to utilise this through the issuance of dividends. However, the settlements legislation precludes you from taking advantage of their allowance. It stipulates that, where any child under the age of 18 receives income of over £100 per year, it is considered part of the parent’s tax liability because children are minors. There is therefore no significant tax benefit to making young children shareholders, other than to extract small amounts of profit from the company.
Once a child is 18 and over the rule no longer applies. It enables them to receive up to £13,570 in dividends tax-free (made up of their personal allowance and dividend allowance) assuming they have no other income. However, one catch to this is that, by granting shares, you may attract capital gains tax (CGT) liability. To avoid CGT, it is recommended that you issue shares when the company is newly established so that it has not yet grown in value.
The tax rule when employing your children for the family business
When you are employing your child for your family business, you will need to ensure that you adhere to all UK employment legislation. This includes paying employees at least the minimum wage unless they are an apprentice. Another exception to this rule is where you employ family members who live in your household. This may be particularly useful if you are teaching younger children the importance of earning money. For example, you may be paying your 13-year-old child less than minimum wage to carry out simple administrative tasks such as photocopying, stuffing envelopes, or taking packages to the post office. In this scenario, they would not need to be paid through a PAYE payroll either.
For children over the age of 16, you will need to ensure they are paid through a PAYE payroll with NI contributions deducted if they are earning over the threshold. They are still entitled to earn up to £12,570 tax-free but will have to pay income tax for anything in excess of this amount.
The tax benefit when employing your children for the family
There are no particular tax benefits to employing children for a family business other than their salary is tax-deductible for both limited companies, partnerships, and sole traders. If they are your only employee and are earning over the NI threshold, then you’ll be eligible to claim the EA.
A further tax benefit could arise if you hire your child as a freelancer. This is only likely to be applicable to children over the age of 16. For example, if your child is a talented artist, there is no reason why they could not legitimately set up their own business as a freelance graphic designer. From your own business you would then be able to pay them for their services. This cost can be deducted against your profits, and you would not need to pay NI as you would do if they were an employee earning above the threshold. In this case, you would not be able to claim EA unless you had other employees.
Your child would be subject to income tax on profits earned but would be able to earn up to £12,570 tax-free. However, under these circumstances there is one important factor to take note of and that is their employment status. They would need to be able to prove that they are a genuine freelancer in order to not fall into the scope of IR35.
Business expenses to claim through a family business
Generally speaking, if an asset supplied by a business to employees is available for the employee’s personal use, it creates a benefit-in-kind which attracts both income tax and NI contributions. However, there are some useful assets which may have dual purpose (for work use as well as personal use) that can be expensed by the business and benefit family members working for the business:
- Mobile phones: For limited company family businesses, so long as the phone is purchased by the company and the contract remains under the company’s name, you can provide one mobile phone or sim card to a family member who is an employee in the family business without having to pay income tax or NI contributions. This is even where they use the mobile phone for personal calls. For sole traders, you can provide a mobile phone to family member employees so long as 30% of the time spent on calls is for business purposes. To calculate this, we would recommend obtaining an itemised phone bill. If this is not possible, supplying a mobile which is strictly to be used for business only would be an acceptable business expense.
- Laptops or computers: For limited companies, HMRC regulations stipulate that laptops, computers, and other such devices, must be supplied to the employee for the main purpose of enabling them to perform their duties. Personal use should be minimal otherwise the device does become a benefit-in-kind. However, as HMRC are unable to provide definitive guidance on how much is considered to be insignificant personal use, they have confirmed that the real test as to whether the device would attract tax is whether it has been supplied for sufficient business reasons. Sole traders are advised to claim only a portion of computer or laptop cost as a business expense. For example, if you intend to use the computer half the time for business and half the time for personal use, then claim 50% of the cost as a business expense.
Tax considerations when passing on a family business
Succession planning is an important consideration when it comes to running a family business, especially if you want to ensure that there is someone to continue management of it once you are no longer able to do so yourself. Normally, a transfer of a business would lead to a CGT liability, however there are some tax relief options that you can make use of to defer this. An exception to this is where you choose to gift your business to your spouse or civil partner (providing you are not separated or in proceedings for a divorce). This is because passing assets between spouses or civil partners is exempt from both CGT and inheritance tax.
However, if you are planning to give or sell your business to your children (or other family members whether that be siblings, nephews/nieces etc) then you may want to consider two different tax relief options. Firstly, holdover relief may be a viable option. Holdover relief allows for the donor of the gift (you) to avoid paying any CGT on the gift made, and instead the recipient takes on the CGT when they dispose of the asset.
For example, you gift your child some business shares. The current market value of the shares is £50,000 but were £15,000 when you purchased them originally. Under normal CGT rules, you would be required to pay tax on the difference in value (£35,000). By using holdover relief, you pay no CGT, but your child will be responsible for paying CGT when they dispose of it in the future. If your child then subsequently sells the shares which then increase in value to £55,000, they will need to pay CGT on the difference between £55,000 and the original £15,000 (CGT needs to be paid on the value of £40,000).
To be eligible to use holdover relief, you can be giving away business assets from a sole trader, partnership (so long as you are allowed to do so as stipulated in your partnership agreement) or company shares (so long as you hold at least 5% voting rights); however the assets must be part of a trading business as opposed to an investment business, and the business should not be listed on any stock exchange markets. Whoever you are gifting your business to must be a UK resident and remain so for at least 6 years after the gift has been made, otherwise tax becomes immediately chargeable. To use holdover relief, you must jointly apply for it with HMRC between yourself and whoever you want to gift your business assets to. You will complete the holdover relief form and include it with your own self-assessment tax return.
A second tax relief option is to use business relief. This relief does not defer or minimise your CGT, but instead reduces inheritance tax on your estate by either 50% or 100%. 100% inheritance tax relief is available on businesses or an interest in a business or shares in an unlisted company, whilst 50% inheritance tax relief is offered on shares which control more than 50% of a listed company; any land, building or machinery owned by you but used by the business; and any land, building or machinery that is used by the business but held in a trust.
To be eligible to use business relief, you must have owned the business assets for at least 2 years. If you inherited the business assets from your spouse or civil partner, then the combined period of ownership needs to be at least 2 years to qualify. To claim business relief, the executor of your will or administrator of your estate will have to complete two forms and submit to HMRC. Form IHT400 is the inheritance tax account form which needs to be completed to show calculations of inheritance tax due. Schedule IHT413 is completed and submitted alongside it which makes an application to claim for business relief.
Hire an accountant for your family business
Using an accountant for your family business can be beneficial if you don’t have the time to manage your tax and accounting obligations or where you don’t have the skills or knowledge to do so. If you want to be able to focus more on your family as well as the business, then why not “share” some of the workload and get some extra support? Get in touch today by completing our contact form to discuss your requirements and receive a free personalised no-obligation quote.
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