Revenue takes a chopper to family firms' tax breaks

Small family companies may be feeling battered and bruised as they face a barrage of attacks from the Inland Revenue, which seems determined to undermine their business structure.

Many of these companies are incorporated to restrict their liability if the business does not go as well as hoped, and to take advantage of government tax breaks. For example, a company with profits of less than £10,000 pays no corporation tax.

But the draconian IR35 rules represent the first hurdle for family firms. These come into play when an individual offers their services through an intermediary - such as a company - to a client. The individual has to consider whether their relationship with the client is similar to one that exists between an employer and an employee.

If there is an effective employer/employee relationship, the person offering their services has to calculate how much they would have owed in tax and national insurance contributions (NICs) had they been an employee, and pay the extra to the taxman. The main blow for those caught by IR35 is that they can no longer benefit from paying themselves primarily in dividends, which was a useful NIC-saving route.

If the company manages to escape IR35, the second hurdle is the settlements legislation. Although these laws have been around for about 70 years, the Inland Revenue is now interpreting them slightly differently. The legislation allows the Revenue to reallocate income where it has been diverted to save tax. In this event, the Revenue can seek back-tax plus interest and penalties, which could mean a bill of several thousand pounds.

Take, for example, a business with just two shareholders, a husband and a wife, who each have a half share in the business. The husband does the majority of the work, while the wife provides administrative support, such as making sure bills are paid, collecting debts and keeping the books up to date. She also undertakes the demanding job of looking after their children, thus freeing up the husband to work. He is a higher rate taxpayer, while she pays tax at the basic rate. They pay themselves primarily in the form of dividends, which is seemingly encouraged by the tax system as it is a more efficient way of extracting funds from a company.

On the basis of its reinterpretation of the settlements legislation, the Revenue might seek to reallocate sums received by the wife and treat them as if they were the husband's income. As he is a higher rate taxpayer, there would be more tax to pay, and if the arrangement had been in place for some time, the Revenue could seek back-tax plus interest and penalties.

However, small businesses can minimise the Revenue's onslaught. Ideally, they should consider the set-up at the time the company is established, seeking advice from a tax adviser or accountant if necessary.

It is wise not to use methods of drawing income from the company that involve giving income solely to the lower rate taxpayer (eg preference dividends, dividend waivers or giving dividends to children). Arrangements of this type are likely to bring the settlements legislation into play.

Shares held by husband and wife should be ordinary shares, as these do not simply yield income but constitute a greater stake in the company. Be aware, though, that the Revenue has suggested it may challenge even these situations under the settlements legislation.

If the lower tax-paying spouse is assisting in the business in any way, this should be carefully documented as evidence of their contribution.

If a spouse has a higher-profile role, consider splitting the shareholding to reflect this or placing the shares in joint names. It might also be possible to enhance the capital value of the business by retaining more funds within it.

Certain aspects of the Revenue's latest interpretation are controversial and may be challenged in the courts. But until then, family companies should decide whether to take preventative action now.

Francesca Lagerberg is national tax director at Smith & Williamson, the professional and financial services group. Contact: 020 7637 5377 or www.smith.williamson.co.uk