How Your Children Can Save You Tax
Children can generate huge tax savings
AS A FATHER of four, I know as well as anyone what a strain children can put on your finances. So how about turning the tables and seeing what tax savings your children can generate for you?.
The latest information can be found in our guides Salary versus Dividends and Putting It Through the Company
The first major benefit is Tax Credits. There is no limit to the income level at which Tax Credits are available (if you have enough children) and there are considerable savings to be made by planning your affairs with Tax Credits in mind.
Employing Children
Paying salaries to your children is a good way to reduce your taxable profits but which children can you legally employ?
With some limited exceptions for specific jobs (e.g. acting or modelling), it is generally illegal to employ children under 13. This will rule out most businesses from employing very young children, although there will be exceptions.
The position for 13-year olds depends on local by-laws. Some areas allow them to do limited work, some allow them to do the same work as a 14-year-old and some do not allow them to work at all.
Children under school leaving age may do ‘light work’ (e.g. office work) provided that it does not interfere with their education or affect their health and safety. Certain types of work (e.g. factory work) are prohibited and any business employing children under school leaving age must obtain a permit from the local authority.
Subject to these points, children still attending school can work up to two hours most days. On Saturdays and weekdays during school holidays this is increased to eight hours (five hours if under 15). Working hours must fall between 7 am and 7 pm and are subject to an overall limit of 12 hours per week during term time or 35 hours during school holidays (25 hours if under 15). The child must also have at least two weeks of uninterrupted holiday each calendar year.
16 and 17 year olds over compulsory school age can generally work up to 40 hours per week and can do most types of work, although some additional health and safety regulations apply. Children aged 18 or more are mostly subject to the same employment rules as anyone else, including the working time directive.
In essence, therefore, you can generally employ any of your children aged 13 or more and pay them a salary which is deductible from your own business income.
How Much Can You Pay and How Much Should You Pay?
A salary paid to a child must be justified by the amount of work which they actually do in your business. If you employed your 15-year old daughter to answer your office phone one hour each evening, you could not justify paying her a salary of £30,000 but a salary of, say, £1,250 should be acceptable.
The national minimum wage applies to any employee aged 16 or more, with reduced rates for those aged under 22 or undergoing training.
Subject to this, however, there is no fixed rate of pay which applies to children. The rate paid must, however, be commercially justified – in other words, no more than you would pay to a non-family member with the same level of experience and ability in the job. For a child with no experience carrying out unskilled work, the national minimum wage for 16 to 17 year olds of £3.57 per hour represents a good guide. Where the child has some experience, or the role requires some skill, a higher rate will often be justified.
Assuming that a rate of £5 per hour can be justified, the maximum salaries which a child could earn would be approximately as follows:
13/14 year olds: £3,780
15+ but still school age: £4,380
Over school age but under 18: £10,400
Subject to this, a salary of up to £6,475 could be paid tax-free to a child aged under 16 with no other income. For those aged 16 or more, any salary in excess of £5,715 will give rise to both employer’s and employee’s National Insurance at 11% and 12.8% respectively.
Within these limits, every £100 of salary paid to a child by a higher rate tax-paying sole trader will save £41. Savings of up to £61 will be available in some cases next year.
Looked at another way, a higher rate taxpayer needs before tax income of £169.49 to be able to put £100 into a child’s hands as pocket money. Alternatively, you can get them to do some work, pay them £100 and be left with £69.49 to spare (£41 after tax).
Better still, if you’re also claiming Tax Credits, that £100 paid to the child could save you £80! (£40 Income Tax, £1 National Insurance and £39 Tax Credits)
A company owner paying their child £100 would save between £21 and £29.75 in Corporation Tax. For a director/shareholder paying higher rate Income Tax, this could also replace £133.33 of their own dividend income (equivalent to £100 after tax), thus providing a total saving of up to £63.08, or even £115.08 if claiming Tax Credits.
Freelance Children
Adult children may sometimes have their own business. In fact, although unusual, it is also possible for younger children to set up their own business.
For example, let us suppose that your 16 year-old daughter is particularly good with computers. There is nothing to stop her setting up her own I.T. consultancy. You could then give her the contract for the maintenance of your office computers and pay her a normal commercial rate for the work.
You will get a deduction for the amount paid to your daughter. She will be taxable on her business profits in the normal way but this structure has one major advantage over employing her: National Insurance. She will only pay National Insurance at 8% on profits in excess of £5,715 and you will not have to pay any employer’s National Insurance.
Where one of your children provides services to your business, the usual rules on employment status will apply to determine whether they are employed or self-employed. There will, however, tend to be a higher burden of proof in borderline cases.
For children under 16, there is no National Insurance on any form of income, so it will probably be simpler to employ them in any case.
Junior Partners
Taking one of your children into partnership is a good way to reduce the overall tax burden on the family. This has important legal implications but using a Limited Liability Partnership (‘LLP’) is a good way to safeguard the family’s private assets.
For adult children, the position is much the same as taking a spouse into partnership and, once again, has the advantage of reducing the overall National Insurance burden from 23.8% to just 8% on profits between £5,715 and £43,875 allocated to the child (and from 13.8% to 1% on any excess) when compared with a salary.
In theory, there is nothing to prevent a minor child from being taken into partnership, even though they do not yet have full legal capacity to contract in their own right.
For a partnership to exist there must be an agreement for the partners to carry on in business together with a view to profit. This agreement may be express or implied and need not be written (except for an LLP), although this is generally advisable. It must, however, be acted upon and it is here that HMRC will concentrate their attention and declare the partnership to be ‘artificial’ and thus null and void if this is not the case.
In other words, any child you take into partnership must genuinely participate in the business at a sufficient level to justify their status as a partner. Hence, you could perhaps take your 17 year-old son into partnership in your sweet shop, but you are unlikely to be able to take an eight year-old into partnership in your publishing business.
Sharing the Wealth
Passing shares in your private company to your children may enable you to pay out tax-free dividends of up to £39,487 per year to each child.
Whether you sell the shares or gift them, you will be subject to Capital Gains Tax as if you had sold the shares for market value unless you and your adult child jointly elect to hold over the capital gain arising. Your company must be a trading company (or, until 5th April 2010, carry on a furnished holiday letting business) for you to be able to hold over your capital gain and you cannot hold over any ‘realised gain’ where the child has actually paid for the shares.
A sale or gift of normal, ordinary shares to an adult child is currently usually an effective way of passing subsequent dividend income over to that child. Some people have attempted similar planning using special classes of shares which carry rights to income only, or very limited rights to capital. Such schemes are somewhat risky, however, as HMRC could invoke the settlements legislation and deem all income to belong to the transferor.
Gifts of shares to your own minor children are generally ineffective for tax planning purposes. You would be unable to hold over the capital gain arising on the gift. Furthermore, the settlements legislation would apply regardless of the type of shares involved and any subsequent income or gains derived from the shares would be taxed on you.
In some cases, however, a minor child might be able to buy shares in their parent’s company from their own resources, perhaps by using a gift or inheritance received from a grandparent. It is essential that full market value is paid for the shares in order to avoid problems under the settlements legislation. Minor children cannot usually hold legal title to assets, but shares can be held on ‘bare trust’ on their behalf.
Generosity Pays
There are several different ways to save tax by effectively passing some of your business income directly to your children. It is vital to remember, however, that the income must be the child’s to keep. Any arrangements requiring the child to pass the income back over to you will mean that the planning is ineffective and the income is taxed on you. You must truly give to truly save.
Trouble Ahead?
Under the right circumstances, partnership profits or company dividends paid to both children and spouses are currently very tax efficient.
However, in 2007, the Chancellor proposed to introduce new ‘income shifting’ legislation to tax any payments made to a child or spouse who was not active in the business as if they were the income of the parent or spouse who runs the business.
This legislation has been postponed twice but may still come into force in the near future, possibly as soon as April 2010.
To minimise any risk of adjustments under such new legislation, it is advisable to ensure that any child or spouse who is a partner or shareholder is also actively involved in the business.
The information contained in this article on how your children can save you tax is covered in detail in our popular tax guide:Salary vs Dividends by Carl Bayley
This unique and comprehensive guide is essential reading if you're considering saving tax by employing your children.
