If you own and run a business of any size above the simple “one-man” business, or if you want to ensure the continuity of your business when you are not around any more, you obviously going to need to involve other people with that business. This brings with it, of course, all the hassle and headaches of employing people; but that’s not what this article is about. What I’m planning to talk about here is the very important question of how you motivate your senior people financially.
I’m sure that times have changed, even since I first entered the world of work in the 1980’s. People do seem to be much more interested in what they can get out of their career these days: perhaps because the old expectation of a “job for life” and a comfortable pension at the end is pretty unrealistic in almost all areas except the civil service, nowadays. So it seems to me you’re less likely to be able to get that faithful righthand man/woman who simply wants to draw his or her monthly pay envelope, and is quite happy to take on major responsibility in the business in return for a fixed salary.
Status Symbols
Don’t get me wrong: the money is obviously very important, because that’s what pays their bills and helps them to get mortgages. But status is another thing which motivates people. Just giving them the right sort of job title, and making it clear to hoi polloi, beneath them in the business, that they have authority, can be a strongly motivating factor for lots of people.
But there are also far more tangible ways of distinguishing a senior person’s status, of course. One of these is providing them with “perks”, or benefits in kind. And of course, this being a forum where tax is one of the main subjects under discussion, it’s a good idea to find benefits in kind which, as well as motivating the individuals concerned, get you and/or them some kind of benefit as against HMRC.
To deal with the simplest ones first, provision of free car parking at or near the place of work is a tax-efficient way of remunerating, and therefore motivating, individuals. This is straightforward, of course, if you’ve got plentiful parking spaces as part of your business premises: however if you haven’t got any such parking, a season ticket for the nearest multi-storey or pay and display is obviously just as good. And free parking (perhaps because HMRC staff themselves get this?) is a tax-free benefit.
Tax Efficient Benefits
You might like to have a look at the relevant chapter in my book, Practical Tax Planning for Business, to get more detail on this, but there are still a number of ways of providing perks which are either taxed at a lower value than the actual amount of benefit you are giving them, or which are completely tax-free. Another example, in addition to the free parking idea, is mobile phones. If the business takes out a contract to supply a phone for an employee, this can be conferred on the employee completely tax-free.
You will also find in my book details of more sophisticated tax planning techniques, including the provision of company cars. At one time, of course, going back in history again, company cars were regarded as a very good way of conferring status on senior employees, not just from the point of view of motivation, but from tax point of view as well. This all changed dramatically under that dour puritan, Gordon Brown, who as chancellor in 2003 introduced some frankly punitive rules whose aim was clearly to put people off driving cars at all, let along providing them to their employees as perks.
The rules are very rough and ready in their operation, and a commentator made the point at the time that the whole concept of taxing somebody on the value of what they were actually receiving seemed to have gone out of the window. Instead this was social engineering big time. So a person is taxed the same, nowadays, if they have a company car, regardless of how much business use they make of the car, or how little: ditto private use. The tax is also the same regardless of whether the car is a beaten up old banger or a brand new shining status symbol. You are taxed on a percentage of the list price of the car when it was new, regardless of how long ago that was.
Reverse Psychology
Whenever one sees a set of rules that are unashamedly unfair, as the company car rules are, of course, my instinct as a tax adviser is to look for situations where this unfairness can be turned on its head, so to speak, and act as unfairness in favour of the taxpayer. And a classic example of this, which I’ve mentioned before because of its one of my favourite tax planning ideas, is the “cars for kids” arrangement.
This idea works just as well if you yourself are the owner as well as senior employee of the company. Instead of providing a top range Mercedes for yourself on the company, which would give rise to an eyewatering tax and NI charge on the benefit in kind, consider providing a much cheaper, and therefore more environmentally friendly, motor for one of your (or your senior employee’s) children. The benefit in kind is still charged on you, because it’s being provided by reason of your employment not your child’s, but the amount could be considerably less than the actual cost to the company of providing the car. If you consider what the insurance premium for a seventeen or eighteen-year-old is, on its own, not to mention the depreciation, servicing, road tax and insurance etc, a comparatively small percentage of a comparatively small list price is literally a very small price to pay. I’ve seen instances where the amount of tax that had to be paid by the employee, and NI by the company, was less than a quarter of the tax would have been paid if the company had simply shelled out a salary for the employee to provide the same car. And the difference, I’m sure, can be very much more than that.
Going Off Payroll
The phrase “off payroll working” has become very popular recently: which is odd, because the actual practice has been with us for donkey’s years. Going back to the 1980’s again, I remember when people even in accountants’ offices advocated simply taking a person off the payroll and paying them as “self-employed”. All you needed to do, it seemed, was to make sure the individual registered as self-employed by filling in a simple form (which the Revenue didn’t question), and then asking them to raise an invoice for their monthly pay rather than receiving it as salary through PAYE. This was eventually seen to be much too easy, and people who were regularly paid gross out of a company’s bank account were regularly targeted by visiting PAYE inspectors. So, during the 1990’s, a more sophisticated method of saving tax and national insurance emerged. This was for the individual concerned to set up a company, perhaps with spouse as co-shareholder, and invoice the business through that.
Personal Service Companies
This was a cast iron method of avoiding the unwelcome attentions of the visiting PAYE inspector. The situation was quite simply that PAYE cannot apply to money paid to a limited company. This became so popular that the taxman put his foot down with the notorious “IR35” regulations.
What these basically said (and still say) was that, if the company was simply put in the middle, so to speak, of what was “really” an employer/employee relationship, then the benefit of this arrangement, which was the avoidance of national insurance, the ability to share the income with spouses and other household members, and the ability to retain profits within the lower company tax environment, were simply swept away. The way this was done was (and is) by making the intermediary company liable to pay PAYE and NI as if all of its income had been paid out to the individual as salary. So no avoidance of National Insurance, no spreading of income amongst other persons, and no deferral of whatever the top rate of income tax was in the year of payment.
This was all very well, and indeed pretty deadly, in theory. But in practice, from the Revenue’s point of view, it simply didn’t work. The problem was trying to show that you had a quasi employer/employee relationship. This whole concept is actually very complicated, and there is an encrustation of decades of case law, some of which points in different directions. Above all, modern working practices have moved on substantially from the Victorian “master/servant relationship” idea on which all of this case law was based. So the Revenue weren’t winning many cases at all on this.
And this is why the matter has become topical recently. Three years ago, the onus of deciding whether IR35 applied shifted, in the case of public sector “employers”, to the employer. Predictably, a process of back covering commenced. The payer was not going to take the risk of having to meet extra PAYE etc liabilities if HMRC disagreed, and so it was pretty much a “knee jerk” reaction for payers to stick PAYE etc on to payments in this situation.
Winding forward to the present day, this change of the onus of deciding whether IR35 applies was going to be extended to medium-sized and large private sector employees from April 2020. This has now been deferred until 6 April 2021, however, it has already been noticed that most or all of such employers are now waiving the question by basically banning personal service companies all together.
Off Payroll Working for the Owner Managed Business
Once again, though, you can see how the tax adviser’s instinct to turn things of their head can be brought into play here. Changing IR35 in this way for medium-sized and large employers implies necessarily that small employers (and “small” is a highly relative term, here) still basically have carte blanche to use these rules to their advantage.
Let’s look at an example.
Hugh Boss runs a successful rifle manufacturing business, which he has built up over the years. In recent years, he’s wanted to take more and more of a back seat in the business, and has been relying more and more on his henchman, Robin. Robin hasn’t got any shares in the company, but receives a substantial salary, of £150,000 a year plus benefits. The employer’s national insurance on this alone is more than some of the junior employees of the business receive in salary. But on the income tax side, Robin is a 45% taxpayer, and there is also the employee’s contribution to national insurance, so called, to take into account.
Mr Boss takes advice, and following that advice a company is set up for Robin to charge the company for his services. This company has shares issued 50:50 to Robin and his wife, Marion. Marion hasn’t got a job herself, or any earned income, and therefore it’s very tax efficient for Robin Services Limited to pay out dividends, both to her and to Robin. This pushes him firmly down into the lower rates of tax, and uses Marion’s whole £50,000 lower rate band into the bargain. And there’s no national insurance at all, either employer’s or employee’s.
The result is that Hugh Boss, who is merely looking to benefit Robin and thereby motivate him, is able to put his salary up by 13.8%, because he isn’t paying employer’s national insurance any more, without Robin costing him a penny more than he did when he was an employee. So everybody wins except HMRC.
Giving them Shares
You can go a lot further than setting up a personal service company arrangement, of course. In that example of Mr Boss and his right hand man Robin, IR35 is not a problem because we are assuming that Robin is basically running the business, and therefore operates on his own initiative. There is little chance, in reality, that HMRC would be able to make an argument “stick” to the effect that Robin as a quasi employee in these cases.
But why not take things a stage further, and actually give your senior staff shares in your company?
Well, I’ll come on to the difficulties and tax issues that arise if you are looking to do that in a minute. But it’s worth pointing out that not all businesses are set up as limited companies, of course. If you are a partnership or (that close equivalent) an LLP, introducing another individual into a share in the business is actually comparatively straightforward. You simply make them a partner, or a member of the LLP.
When I say this is “simple”, there is a bit of work to do, of course. It’s very important from a number of points of view, if you’re bringing someone into partnership, to make sure that the agreement between you is perfectly clear: preferably written down in black and white. This is important not just from the point of view of avoiding misunderstandings or disputes later: it can also be crucial from the tax point of view. Here’s another little scenario to explain what I mean.
Mr and Mrs Slapdash are the sole members of Slapdash LLP, a plastering business. They bring in as a third member their long standing employee Reg, but don’t bother to do anything about drawing up an LLP agreement. (It isn’t compulsory, under the law, to have an LLP agreement.) All seems fine, with Reg receiving an equal one third share of profits each year, until a letter of enquiry from HMRC lands on their doormat.
One of the questions that taxman asks relates to Reg’s admission into partnership. The inspector asks to see a copy of the LLP agreement, and Mr Slapdash innocently replies that there isn’t one.
OK, responds the taxman, at the absence of an agreement default is that the three of you are equal partners.
“That’s fine”, says Mr Slapdash. This is what we’re doing: Reg receives a third of the profits.
“Not so fast”, says the inspector (who has a taste for melodramatic dialogue). It’s not just the income profits you’re now sharing equally with Reg. You are also sharing capital profits equally. “What about the workshop that is in the LLP balance sheet, at a revalued figure of £500,000? How much did that cost you?”
It turns out that the property had gone up in value, from when Mr and Mrs Slapdash originally bought it, by £300,000, and therefore a £100,000 capital gain is deemed to have been made by them when they brought Reg in as a partner. And they had no idea this was happening.
The moral of the above story is simple. Make sure that you have an LLP agreement when you bring someone in like this, and make sure it’s been looked at by someone who knows something about tax.
Company Shares
You may think that’s a nasty trap. But it’s nothing to the issues which arise when you’re talking about bringing your top man or woman or individuals into a share in a business which is run through a company.
Put briefly, the problem is that giving shares to an employee is taxable. The value of the shares they get is treated as a benefit in kind like any other benefit in kind, and therefore they would pay income tax on it at their top rate, together with a national insurance charge being levied on the company itself. And a big difficulty with this sort of situation, as if that wasn’t bad enough, is that it’s very difficult to get any firm idea in advance what that value is. HMRC persistently refuse to negotiate values of shares in advance of transactions. Instead, they adopt the extremely unhelpful approach of insisting that you do the transaction first, and then argue about the value later. It’s almost as if HMRC see their mission as being stifling business by stopping people bringing in fresh blood. No staff member is going to want to take the poison chalice of shares in a company which land him/her with a tax charge without any money being provided to pay it. An impasse.
The Way Out
There is a way out, or a number of suggested ways out, of this an impasse, though. One is to issue shares to the right hand man which are restricted in their entitlement over the company’s assets. If you issue “funny” shares which don’t give any entitlement to the current value of the business, but only to future growth in value, this arguably should avoid a tax charge, because in principle the shares should be worthless when they are issued.
This isn’t by any means a cast iron solution, unfortunately, though. It is not beyond the wit of some “ivory tower” HMRC share valuation person to claim that the shares nevertheless had some value because of their expectation of growth in the future, or even because they were expected to, and/or did, start paying dividends.
So a much more common solution to the problem in practice, I find, is the use of an Enterprise Management Incentive (EMI) Scheme. The common form of these schemes is that the individual is given an option over shares, rather than shares themselves. What’s more, this option isn’t exercisable, usually, until such time as the company is sold. At that point, the individual of course has the funds, by definition, to buy the shares, because they will immediately be turned into cash on the sale. Therefore a fair amount can be paid for the shares: and the crucial point of EMI Schemes is that this “fair” amount is the value of those shares when the scheme was first set up, rather than at the subsequent date of sale. So a significant amount of benefit can be handed over to the individual on which the individual will pay capital gains tax rather than income tax (therefore at a much lower rate), as a result of the sale.
EMI is a solution, then, to all those situations where the business owner wants to bring key people into a share of the ultimate sale proceeds, but isn’t in a position to give them a share in the business because of the stupid tax rules I’ve been talking about.
But be warned: when the company is actually in negotiations for its sale, you’ve missed the boat, because it’s too late to introduce EMI with any tax efficiency at this point. The time to think about such matters is when the individual concerned might still be motivated by the prospect of a future share in the business.
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