Beware salary waiver tax traps

With the downturn in the economy showing few signs of easing, a growing number of businesses are looking at ways to get through some difficult times. For some clients, often owner managers, one option is to waive their salary to alleviate some of this pressure. Such arrangements are generally decided on an ad hoc basis, often at the end of each month, depending on cash available in the business.

A salary waiver occurs when an employee or director gives up their rights to receive salary, for nothing in return. One might assume that if a person has not actually received a salary payment then there would be no tax due. However, this is not always the case.

If the salary has been waived before it is regarded as received for employment income purposes, the waived salary will not constitute taxable earnings of the employee or director. Where the salary waived has already been treated as money earnings received by an employee or director for income tax purposes, there is an obligation for the employer to account for income tax under Pay As You Earn and national insurance contributions.

Broadly, earnings are treated as received for tax purposes when payment is made or, if earlier, when a person becomes entitled to payment of, or on account of, the earnings. For directors, there are additional rules which can result in earnings being treated as received on an earlier date. For example, this would occur where sums on account of earnings are credited in the company accounts or records, irrespective of whether the director can draw down such sums.

As a result, if an employee or director is entitled to receive payment of their earnings before the payment is actually made, they will be treated as having received the earnings as soon as the entitlement to payment of the earnings arises. In such cases, tax is therefore due, regardless of whether the earnings have been received or not.

While a salary waiver may achieve the desired commercial results, a valid salary sacrifice may offer a more appropriate solution. In such cases, an employee usually gives up the right to part of their future cash salary in exchange for a non-cash benefit, such as childcare vouchers or employers’ contributions into a pension scheme. However, the individual also has the option to sacrifice salary in return for nothing.

For a salary sacrifice arrangement to be effective, the terms of the employment contract set out between the employer and employee must be varied to reflect the change in entitlement of the employee, before the changes are implemented.

Fundamentally, salary must be sacrificed before the employee is entitled to it, and so care should be taken particularly where salary is paid in arrears, in whole or in part. There are a number of other considerations when sacrificing salary, including ensuring compliance with national minimum wage legislation. If employees and directors wish to help their business by waiving their right to salary, they should ensure this is implemented as tax efficiently as possible.