Team Effort? How to split profits with your spouse

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Should you make your spouse a business partner to save tax?

Over the last few months you may have supplemented income from your company by doing freelance work – it might even have become a lucrative sideline. Naturally, there will be tax to pay – but can you legitimately reduce it by splitting income with your spouse?

By splitting income with your spouse or civil partner you can reduce the tax bill on it if they pay tax at a lower rate than you. However, HMRC do tend to look at such arrangements with suspicion. Typically, HMRC attacks income splitting arrangements that involve one spouse paying the other a salary to reduce their business profits or giving them shares so that profits can be diverted in the form of dividends. By contrast HMRC rarely attacks arrangements where profits are diverted to a spouse by making them an actual partner in a business.

HMRC’s view of partnerships

In English law (which also covers Wales) a partnership is created simply by two or more persons sharing business profits. This makes it difficult for HMRC to dispute the existence of a partnership and, consequently, the allocation of profits between the partners. In fact, HMRC’s internal guidance says, “It may be possible in these cases to challenge the spouse or civil partner’s status as a partner, but such a challenge is often very difficult to sustain.” Notwithstanding HMRC’s reluctance to challenge the existence of a partnership, drawing up a partnership agreement to formalise the arrangement is advisable, and we can assist on this front.

Tax avoidance?

Having cleared the initial hurdle of creating a partnership, you might still be concerned that HMRC could attack the arrangement where you split the profits with your spouse in order to avoid tax. Surprisingly, HMRC’s guidance helps out again. It says, “A spouse or civil partner is sometimes taken into partnership wholly or mainly to maximise the benefit of the tax reliefs that are available” , it continues, “It is worth emphasising that a partnership is not a sham merely because it is set up to save tax” and “You cannot challenge the apportionment of profits, as you can a wage, by reference to the value of the partners’ contribution to the firm’s activity”.

HMRC’s generally relaxed attitude to partnerships is tempered by the so-called ‘settlements legislation’ which allows HMRC to block tax savings by treating the profits allocated by the partnership to a spouse who’s not active in the business as taxable on the other spouse. However, the good news is that this type of attack is fairly simple to rebuff as the settlements legislation only applies if the inactive partner is only entitled to income, i.e. a share of the profits, but not a share in the partnership’s capital assets, e.g. goodwill etc.

In Summary

If your spouse pays tax at a lower rate than you, forming a partnership with them is a legitimate way to split income. HMRC won’t attack the arrangement as long as your spouse is entitled to a share of the partnership’s capital assets, e.g. goodwill, as well as the profits – but to make the arrangement robust, you should evidence this by drawing up a partnership agreement which outlines each partner’s entitlement to income and capital.
For further information, contact us.