The last few years have seen several important changes to the taxation of termination payments. With these in mind, how can you minimise the tax and NI bills when your company parts ways with a director?
Trouble in the board room
Usually, when a director is forced to resign a financial agreement can be negotiated with the company. It’s vital that the tax and NI treatment of any payment is discussed before finalising the deal. A tax and NI-efficient deal will be advantageous for the company and the director.
It’s tax free, isn’t it?
You probably already know that payments for the termination of employment are tax and NI free up to £30,000. For amounts in excess of that the director is taxable and the company must pay NI. The trouble is that not all lump sums paid on termination qualify for the exemption.
Trap. Employers must use a special formula to work out if and how much of a termination payment is in lieu of notice (PILON) and deduct tax and NI on that part as if it were salary.
When does the exemption apply?
After deducting a PILON the remaining termination payment doesn’t automatically qualify for the exemption. It applies only if the payment is “for” the termination and not just “because” of it. For example, a lump sum paid to a director because their contract says they are entitled to one is payment because of the termination and not for it. Similarly, an entitlement to accrued sums, such as bonuses, even if they aren’t mentioned in a contract, are because of termination and not for it.
No exemption can be costly
Tax and NI reduces the amount of termination payment a director will get in their pocket. In turn, that can push up the cost to an employer as the director will negotiate hard for a larger payout if they’re going to lose out to HMRC. Example. A company pays a director £20,000 on termination to which the exemption applies; the higher rate paying director receives £20,000 and the cost to the company is the same. If, however, the payment is liable to tax and NI, it will cost the company up to £39,250 if the director is to receive £20,000.
Trap. HMRC often takes an aggressive approach if the exemption is claimed. Its usual argument is that a payment is in recognition of past services provided by the director and therefore taxable as earnings. Defending such an attack can be time consuming and costly with no guarantee of success.
Tip. Unlike PILONs or accrued rights to pay, payments which are made voluntarily, or as compensation for the loss of employment-related rights or, if appropriate, breach of contract, qualify for the exemption. Therefore, it’s important to describe payments properly in any correspondence.
Tip. Making a large contribution to a departing director’s pension plan is a way to avoid tax and NI where an exempt payment can’t be made. Within limits, employer contributions aren’t liable to tax and NI and they give the recipient scope for tax planning.
This article has been reproduced by kind permission of Indicator – FL Memo Ltd. For details of their tax-saving products please visit www.indicator-flm.co.uk or call 01233 653500.