Tax Doctor:
Mark McLaughlin
ATII ATT TEP

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November 2002

Q:

My girlfriend and I have lived together for several years and she helps me with my business on an informal basis. She doesn't have any other earnings. I operate as a sole trader and I make about £18,000 a year profit. I would like to pay her about £100 a week, and I wonder if it would be more tax-efficient to employ her or to make her a partner of the business?

A:

There are a number of points to consider here, some of which are non-tax matters. However, I will stick to the tax issues:

In general

• You wish to pay 'about' £100 from your sole trader business. The personal allowance for 2002/03 is £4,615, or over £88 per week. So why not pay up to your girlfriend's personal allowance instead? Provided she receives no other income or benefits from the business, there should be no tax to deduct from earnings up to that level. The same principle applies whether she receives a salary of £4,615 or a profit share of £4,615 as a business partner.

As an employee

• There is no National Insurance (NI) for you to pay as an employer, if your girlfriend receives a salary of up to £4,615 a year. As far as employee's NI is concerned, there is a 0% rate on earnings between £3,900 and £4,615 per annum. Why 0%? Because this rate entitles employees who are paid within that band to state benefits, whilst not actually having any NI deducted from their pay.
  
  
• Any salary paid to your girlfriend should be justifiable in relation to the duties performed. It must also be physically paid (e.g. by cheque, as opposed to merely a 'book entry' in your accounts), and be recorded as 'wages' (or similar) in your books. This will hopefully ensure that the Inspector of Taxes is unable to raise any objections when a deduction is claimed against your profits for the amounts paid.
  
  
• You indicate that she helps you with the business on an informal basis. How many hours does she work? You will need to ensure that your girlfriend's salary meets National Minimum Wage (NMW) requirements (the current rate is £4.10 per hour, increasing to £4.20 per hour from 1 October 2002). You must be able to prove that this is the case, which may mean keeping a record of the number of hours she works. There are certain exceptions to the NMW requirements, such as for workers who participate in the family business. However, to qualify the worker must be a member of the employer's family and share his home (for further information, have a look at the DTI guide to the NMW, or visit the Inland Revenue's website (www.inlandrevenue.gov.uk) under 'National Minimum Wage').

As a partner

• What type of business do you run? There is an important distinction between a 'trade' and a 'profession' because only qualified persons may carry on certain professions (e.g. dentists or solicitors). In any event, your girlfriend should be capable of performing at least some of the business activities.
  
  
• Changes in profit sharing ratios (e.g. on the admission of a partner) do not normally trigger a capital gain on a disposal of 'goodwill' by the partner whose profit share is reduced, although it can happen in some cases (e.g. if the assets in the business balance sheet have previously been revalued, or if a payment is made for the profit share outside the business accounts).

Which one?

Based on a salary (as an employee) or a profit share (as a partner) for your girlfriend, it will make no difference to your tax liability, i.e. your taxable profit is £13,385 (£18,000 less £4,615) either way. From your girlfriend's viewpoint, she will be worse off as a partner. Although her salary or profit share is covered by her personal allowances, as a partner she will be liable to pay Class 2 national insurance contributions of £2 per week.

However, if you both shared profits equally, the overall tax saving would be higher than if you continued as a sole trader. This is illustrated below.

Of course, for these purposes I have assumed that neither of you have significant other income or capital gains for the year, which might push you into the 40% higher rate of tax.

...and finally

It may be worthwhile incorporating your business and running it as a limited company. The rate of corporation tax on company profits will be lower than the personal tax rates you are paying at present, and there is also scope for personal tax savings as a company director and shareholder, such as through the payment of a combination of salary and dividend. Of course, there are a number of considerations to incorporating a business, some of which are non-tax related. The question of whether to trade as an unincorporated business or through a company will be considered in a future issue.

Mark McLaughlin

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