The tale of 'Peter' - running a small business

Francesca Lagerberg, deputy chairman of the ICAEW Tax Faculty and chairman of the small business working party of the Chartered Institute of Taxation, looks at the tax issues affecting a very small company. It will be a familiar tale for many freelancers.

Francesca Lagerberg writes:

This is a tax tale of everyday folk running a small business

We start with Peter who sets up a business. It is a very small business and consists of just him and his wife as the sole shareholders in a limited company.

He works as a consultant and relies on his knowledge of his industry to make a living. He was not really sure which entity to trade through when he set up his business but the clients he wanted to work for were adamant that they were only interested in offering him work if he had a corporate structure. "We don’t want any risk of you being our employee," they remarked.

Shares

Peter bought an off-the-shelf company and he and his wife subscribed for two £1 shares. He is the sole director. His wife does the books and looks after the expenses. She liaises with the accountant and answers the phone if it rings in the house. The rest of the time she is busy bringing up their young family. She is a lower rate taxpayer.

She draws a small salary and so does he. They take the rest of the profits out of the company in the form of a dividend as it saves National Insurance Contributions. They leave very little in the company as they need the funds to meet their outgoings. Children are an expensive hobby!

Peter gets on with the business of trying to win new work and keep existing customers happy. He works long hours. He and his wife keep the company records up to date and file all required tax returns with the Inland Revenue on time.

IR35

In 1999 Peter hears from his adviser about the introduction of a new rule which has been dubbed 'IR35'. It potentially affects people like himself who offer their personal services via an intermediary, such as a company.

If it "bites" Peter, each year he will have to tot up all his income from relevant engagements caught by the rule. He will get a few deductions, most of which are similar to those given to employees, and then the rest will be subject to PAYE and NIC.

IR35 will only apply if his relationship with his clients is akin to that which exists between an employer and an employee. If it does affect Peter, he will have a substantial increase in his tax bill as it will mean his dividend income is subject to more tax than he currently pays.

The IR35 rules look complex and appear to Peter unduly harsh as they seem to be targeting people just like himself, who are trying to build a business. He has not set up his company with tax avoidance in mind and is simply operating through a company because that is how he can win more work. If he had been able to operate as a sole trader he would not have had IR35 concerns.

Case law

Peter consults his adviser and finds to his relief that IR35 does not seem to apply to his case. It’s not clear-cut and there are literally hundreds of tax cases that could potentially be reviewed to argue both for and against his position.

However, he has some winning arguments to deflect any question that he is within IR35. He can demonstrate that he has clear financial risks in his operation. Many of his clients are late payers and he has sometimes had to fight tooth and nail to be paid. He has a number of engagements and is independent of the clients he works for.

He does a project, which he controls, and does not get involved in any other part of his clients’ businesses. He also has a "substitution clause" in his contract with clients which enables him to send along someone to cover for him on the rare occasions when he cannot go to an existing client.

Heaving a sigh of relief, Peter carries on building his business. He is now a higher rate taxpayer and work is going well.

Over the years Peter hears about various tax incentives for "small" businesses such as the research and development tax credit, enterprise management incentives and such like. However, none of these look as if they would help his company.

Section 660A

In April 2003 he hears that the Revenue has issued a Tax Bulletin setting out a series of examples that show how certain businesses which enable income to be diverted away from a higher rate taxpayer to a lower rate taxpayer can be caught by the settlements legislation. This is found in section 660A, ICTA 1988.

If Peter and his wife are within these rules the dividend his wife receives could be reallocated to him and extra tax would be payable, as he is a higher rate taxpayer and she still pays tax at a lower rate. The Revenue appears to have the right to seek tax not just for the existing year but for back years too, especially if it was not clear in earlier years what the arrangements were.

The settlements legislation only applies if an arrangement exists which is bounteous, or not commercial, or not at arm's length, or in the case of a gift between spouses - wholly or substantially a right to income.

Peter and his wife both have shares in the business but he does the majority of the activity which brings in work. The shares are ordinary shares and although his wife is not a director, she does have sway over what dividends are paid out each year.

They operate as a team and from a company law perspective she has a 50 per cent interest in the business. She could in theory choose not to vote to re-elect him as a director each year if he acted unreasonably in how the company was run.

He also knows that if they ever divorced she would be entitled to half the business. They also both think of the business as "theirs" - something they have both contributed to in their own way. He cannot see that her ordinary share is just a right to income.

Peter is unsure if the settlements legislation applies to his case. His adviser explains that the rules are controversial, but points out that his wife is actually doing a lot more in the business than at first sight is apparent.

Now that the children are older she is playing a more active role. They decide to document her work more carefully. They also decide in 2003 that two £1 shares do not give the company much of a sense of "substance" so they increase the share capital.

They put goodwill onto the balance sheet. The business has grown well over the last few years so they decide to retain some funds within it and there are a few capital purchases.

Arctic Systems

Some months later, Peter hears that a case is going to be heard on issues that seem very similar to his own. The case is called Jones v Garnett SpC 432. It takes over three months for the decision to be reached.

When it is concluded the two Special Commissioners hearing the case appear to have disagreed on almost every important point. The more senior Special Commissioner gets the casting vote and finds for the Revenue.

Peter’s position seems even less clear, although the action he took in 2003 gives him some comfort that he can answer any relevant questions from the Revenue. He also notes that the Special Commissioner who found for the Revenue was clearly persuaded in her decision by the fact that the main active spouse in the business was the sole director.

Peter decides it is time to make his wife a director in the company too just in case. He hears that the case may be appealed but it is advisory only, so if it is not appealed, at least it does not have to be followed by higher courts.

Corporation tax

In April 2000 the Government introduced the idea of a starting rate of corporation tax for companies with profits of £10,000 or less. The rate was initially fixed at 10 per cent but fell to nil from the year to 31 March 2003. Dawn Primarolo, the Paymaster General, referred to it as being a "gift horse". At last Peter felt that he had done something right by incorporating.

In December 2003 Peter begins to develop a persecution complex. He hears that the Government is thinking of introducing some measures to tackle those who have chosen to incorporate, apparently to take advantage of the nil rate starting band for corporation tax.

Incorporations rocketed, which is not surprising given that a small company could save several thousand pounds in tax, compared to the tax liability of a sole trader. Peter is not sure what action the Government is going to take but is pretty certain it will not be in his favour. In March 2004 he takes an early dividend - just in case.

From 1 April 2004 the Government introduces a new minimum rate of corporation tax on distributions (which mainly means dividends) of 19 per cent. It affects distributions made to non-corporates, and only affects companies with profits under £50,000. Peter's business has now grown beyond that level so he feels no effect. However, many of his friends with lower profits are hit by the new tax charge.

Discussion paper

Peter takes an interest in current affairs and sees that the Budget 2004 Red Book says that the autumn Pre Budget Statement will include a discussion paper on the "dividing line between employment and self-employment earnings" and the "remuneration of owner-managers".

Luckily his adviser tells him that this will not be yet another shuffling of the tax system to thwart him but an attempt to set an agenda to tackle deep seated tax issues. He may even find that after consultation - which may take several years - his future tax position is clearer and he has more certainty. But he will have to wait and see.

Employee

Peter's business is now doing so well he wants to take on an employee. He looks at what this might involve. He wants to pay the employee £30,000 pa. He works out that with tax and NIC it will cost him £38,633 pa.

He will also have to offer full employment rights, eg. statutory sick pay and maternity or paternity leave. He will be subject to the stringent requirements on unfair dismissal. Peter wonders if instead he should simply use a contractor but could that leave him exposed to a claim for PAYE and NIC if the contractor is later shown to be his employee?

Peter decides he will only take on a contractor if he works through a personal service company and remembers that this is how he started in business.

Complicated

Peter scratches his head and wonders how building a business became so complicated. He has grown a very small enterprise into a bigger company. He has paid taxes. He has contributed to the economy.

He hopes that those preparing the Pre Budget Report discussion paper at the moment remember the good things about his type of business - this time.

He reflects on a comment he remembers from the not too distant past - hadn't someone once described those running smaller businesses as running "the engine-house of the economy"?

But perhaps that was before the myriad tax changes.

Francesca Lagerberg

Francesca Lagerberg is the national tax director at Smith & Williamson. This article first appeared in AccountingWeb's TaxZone.