It is one of the most natural arrangements in an owner-managed business. A spouse handling the admin, a son or daughter covering the phones during a busy spell, a parent who has always understood the numbers managing the books.
And yet family employment is also one of the areas HMRC scrutinises most closely, and the reason is not that the arrangement is inherently suspicious. It is that it has been misused often enough, and in recognisable enough ways, that compliance teams know exactly what to look for. The arrangement that unravels under enquiry is rarely one where someone was doing nothing at all. It is usually one where someone was doing something genuinely useful, but the salary was harder to justify than expected, or the records had not been kept with any rigour, or the payroll had been run casually rather than correctly. Each of those failures looks different on the surface. Each of them produces the same outcome: a tax cost that is higher than if the arrangement had never existed.
Done correctly, this is legitimate and often considerably tax-efficient.
Building on our earlier guide to Self Assessment obligations, this guide covers what HMRC actually requires, where the planning opportunity genuinely lies in 2026, what the new employer NI landscape means for sole director companies considering a second payroll entry, and what documentation separates an arrangement that holds from one that does not.
What you will learn:
- The four tests HMRC applies to family employment arrangements, and why failing any one of them is costly
- Why adding a genuine second employee can unlock the Employment Allowance and change the NI position for the whole company
- What the National Minimum Wage requires in 2026, including the April rate increase
- When auto-enrolment obligations are triggered and what they mean for a company that has never had them before
- What documentation makes the difference between an arrangement that holds and one that does not
Why HMRC pays attention to this
HMRC does not oppose family employment.
It opposes arrangements that reduce a tax bill without a corresponding economic reality behind them. The line between the two is drawn by four questions that any compliance officer will ask when reviewing the books: is the work genuine, is the rate commercially justifiable, is the money actually being paid, and are the records consistent with what is being claimed?
Each of those sounds simple. In practice, any one of them can become a serious and expensive problem.
A spouse on the payroll as a bookkeeper whose involvement consists mainly of occasionally glancing at a spreadsheet is doing something, but probably not enough to justify a full-time salary. A rate set at two or three times what the business would pay an unconnected person for the same work is difficult to defend regardless of the family relationship. A payment that sits in a joint account and is never separated from household money creates an evidential gap.
And timesheets reconstructed from memory at year end, rather than kept at the time, are not records in any meaningful sense, because they cannot be verified and HMRC knows it.
Targeted enquiries into owner-managed business payrolls increased through 2024 and 2025, and the investment in additional HMRC compliance resource suggests that trajectory will continue. That does not make family employment riskier than it was. It makes poorly structured family employment riskier than it was, which is a meaningfully different thing, and the difference is entirely in the quality of execution.
The four tests in practice
The first test is whether the work is genuine and necessary. The family member must be doing something the business actually needs done, and the role must be real enough that you could describe it clearly to a third party and point to evidence that it was performed. That description sounds straightforward, but the bar is higher than many directors assume.
A role that cannot be described with any specificity is a problem before HMRC even asks.
A partner who manages incoming enquiries, processes supplier invoices, prepares client notes, and handles the firm’s correspondence is doing real and varied work. The hours may be part-time and the arrangement informal by the standards of a larger organisation, and neither of those things is problematic in itself.
What becomes problematic is when the tasks listed were already being covered by someone else, when there is no evidence in the business’s operations that the work was being done, or when the role changes description each time it is asked about.
Officers who review these arrangements are experienced, and descriptions that sound plausible in the abstract tend to fall apart under methodical questioning.
The second test is whether the pay is commercially reasonable, and this is where HMRC’s approach is notably less formulaic than directors sometimes hope. There is no precise ratio beyond which a salary becomes indefensible, no bright line that separates acceptable from excessive. The reference point is what a commercial employer would pay an arm’s length employee to perform the same work in the same market.
Paying above that rate is not automatically wrong, but the excess requires justification, and paying substantially above it without a clear reason is the arrangement most likely to attract challenge and least likely to survive it.
The third test is whether the money actually changes hands, and it catches more businesses than might be expected.
Cash is the danger.
HMRC has specific powers to request evidence that wages were paid to the family member rather than simply entered in the accounts, and cash payments within family businesses are a known red flag for compliance teams. A bank transfer from the company account to the family member’s personal account, recurring at the frequency of the payroll, is the clearest and simplest form of evidence. The fourth test, proper PAYE compliance and real-time RTI submissions, follows directly: wages paid to a family member must be processed through payroll and reported to HMRC before or on the date of payment, exactly as they would be for any other employee. Recording the salary in the accounts at year end and submitting it retrospectively does not satisfy the legal requirement, and it signals to any reviewing officer that the payroll was not being run as a genuine employment arrangement would require.
The double taxation trap
If HMRC successfully argues that a salary paid to a family member was not wholly and exclusively for business purposes, the deduction is disallowed in computing the company’s taxable profit. The salary does not disappear, however. It remains employment income in the hands of the family member and is taxed accordingly.
The result is a tax cost at both company and individual level from the same payment: the company pays corporation tax on profits that include the disallowed amount, while the family member pays income tax on wages for which the company received no relief. For a salary even modestly above the commercially justifiable rate, the combined cost can significantly exceed the saving the arrangement was designed to achieve.
Setting the salary conservatively from the outset, clearly within the range a commercial employer would pay, is both the compliant approach and the most tax-efficient one. They are the same thing.
The Employment Allowance opportunity
One of the more significant changes to the employer NI landscape over the past year has altered the economics of family employment in a way that is not yet widely understood. It makes proper family employment more valuable now than it was before April 2025.
From April 2025, employer’s National Insurance became payable from a much lower salary threshold than before.
The secondary threshold dropped from £9,100 to £5,000, and the rate increased from 13.8 per cent to 15 per cent. For a sole director company, this meant that paying any salary above £5,000 a year immediately triggered an employer NI liability.
The Employment Allowance, which can offset up to £10,500 of employer NI, sounds like the obvious solution. But sole director companies, where the only employee is also the sole director, are excluded from claiming it.
The allowance was unavailable. The NI bill had no relief. That remains the position for any company with a single payroll entry, and it is the context that makes the family employment question financially significant in a way it has not always been.
Adding a genuine second employee changes that position entirely.
A company with at least two employees is generally eligible for the Employment Allowance, which in 2026/27 stands at £10,500 and offsets the company’s employer NI liability pound for pound.
For a company paying a director’s salary of around £6,500 and a family member’s salary of, say, £12,570, the combined employer NI liability before the allowance is roughly £1,361, calculated at 15 per cent on earnings above the £5,000 secondary threshold. The Employment Allowance absorbs that in full, leaving a net employer NI cost of nil on both salaries while the corporation tax deduction for both remains.
A family member doing genuine and necessary work is therefore not only contributing commercially but potentially unlocking a relief the company could not otherwise access. That is a meaningful planning outcome, and it depends entirely on the employment being real.
The Employment Allowance question is one we now raise in almost every conversation with a sole director client who has a spouse or partner doing real work in the business. Many of them are already on the payroll informally. What they have not always done is check whether their eligibility for the allowance has changed, and whether the broader tax planning position has been reviewed as a result, or whether the payroll has been run in a way that would actually support the claim.
Advisory observation, Xeinadin Richmond
Minimum wage and what commercially reasonable means in 2026
From 1 April 2026, the National Living Wage for workers aged 21 and over rose to £12.71 per hour. For workers aged 18 to 20 the rate is £10.85 per hour. These are legal minimums, not starting points, and the family relationship provides no exemption from them.
A family member working ten hours a week must receive at least £127.10 for that week.
There is one limited exception worth noting, though it applies less often than directors sometimes assume. Officers of a company, meaning directors and company secretaries acting in that capacity, are not subject to minimum wage rules unless they also hold an employment contract. A family member appointed as a company secretary but performing no contracted employment duties sits outside the minimum wage framework. In practice, most family members in small businesses are employed rather than appointed as officers, and the minimum wage applies to them in full.
The commercially reasonable rate sits above the minimum wage floor and is calibrated to the local market for the type of work involved. In Richmond and across South West London and Surrey, professional services salaries tend to run higher than national averages, which means that the defensible rate for administrative, client support, or marketing work is correspondingly higher than it might be elsewhere. That is not an argument for paying above what the role warrants. It is a reminder that the relevant comparator is the local market in which the business operates, and that documenting that comparator at the outset is considerably easier than reconstructing it under enquiry.
Auto-enrolment: the obligation that arrives uninvited
This is the one that catches the most directors off guard.
A sole director company with no other employees has no automatic enrolment duties. The moment a second employee joins, that changes entirely. The company becomes an employer subject to the full auto-enrolment regime, which means assessing every worker against the eligibility criteria and enrolling those who qualify into a qualifying workplace pension scheme, without being asked, and within the legally required timeframe.
The Pensions Regulator does not treat ignorance of the obligation as a mitigating factor.
The eligibility criteria for automatic enrolment require that the worker is aged between 22 and State Pension age, earns above the earnings trigger of £10,000 per year, and works in the UK. A family member employed at £12,570 a year and aged over 22 meets all three criteria and must be enrolled.
The minimum employer contribution is 3 per cent of qualifying earnings, and the minimum employee contribution is 5 per cent.
Failing to enrol an eligible worker, or enrolling them late, triggers fixed penalties that escalate the longer the breach continues, and the regulator’s compliance team actively pursues small employers who fail to meet their obligations. The family relationship, again, provides no exemption, and the scale of the business does not reduce the legal requirement.
Where a family member earns below the £10,000 trigger but above the Lower Earnings Limit of £6,240, they are a non-eligible jobholder with the right to opt in. Many directors choose salary levels that keep a family member below the trigger deliberately. That is a legitimate approach, but it needs to be made as a deliberate decision with the numbers modelled in advance, not as an accidental outcome that avoids enrolment by luck.
What records actually protect you
The question HMRC asks when reviewing a family employment arrangement is not whether the arrangement was genuine. It is whether the arrangement can be shown to have been genuine. That distinction matters more than most directors appreciate until the point at which it matters very much indeed.
An employment contract is the starting point, and it cannot be skipped.
The contract does not need to be elaborate. It needs to describe the role, specify the hours and the rate of pay, and set out the reporting arrangements.
For part-time or variable-hours arrangements, the basis on which hours are agreed should be stated. The contract should be signed and dated at the time the employment begins, not reconstructed afterwards, because a document that cannot be shown to predate the period it covers carries almost no evidential weight with an enquiring officer.
One of the things HMRC looks for is whether the employment documentation was created contemporaneously with the employment or produced in a hurry once questions were asked. A short, clear document signed at the outset, however informal the arrangement may be in practice, removes that question entirely and costs almost nothing to produce.
Timesheets are the second layer, and contemporaneous means at the time, not approximately at the time.
A shared calendar, a brief weekly email log, or a signed paper sheet all serve the same evidential purpose. None of them need to be sophisticated.
What they need to do is exist when the hours were worked, not be assembled from memory when the accounts are under review. The gap between a timesheet completed each Friday and a timesheet reconstructed six months later is not a matter of detail: it is the difference between evidence and reconstruction, and an experienced compliance officer can usually tell which is which.
Bank records confirming that salary was transferred from the company account to the family member’s personal account at the frequency the payroll specified complete the picture. Where the family member uses a joint account with the director, the transfer still needs to happen. The movement of money is the evidence of payment, and a bookkeeping entry without a corresponding bank transaction is not evidence that money changed hands.
Finally, RTI submissions must be made in real time, before or on the date of payment, not at year end and not in one retrospective batch. Submissions made in arrears are one of the clearest signals that a payroll is not being run correctly, and that signal tends to attract more scrutiny rather than less.
Key takeaways
- HMRC applies four tests to family employment: genuine work, commercial rate, actual payment, and proper payroll compliance. Failing any one of them is likely to cost more than the arrangement ever saved.
- Adding a genuine second employee to the payroll can unlock the Employment Allowance of up to £10,500, which offsets the company’s employer NI liability in full. For sole director companies this allowance is otherwise unavailable.
- The National Living Wage from April 2026 is £12.71 per hour for workers aged 21 and over. Minimum wage rules apply to family members in full.
- Auto-enrolment obligations activate the moment a second employee joins. A family member earning above £10,000 a year and aged 22 to State Pension age must be enrolled in a qualifying pension without being asked.
- The double taxation trap means a disallowed salary deduction is still taxable on the family member. Getting the rate wrong creates a tax cost in two places simultaneously.
- An employment contract, contemporaneous time records, bank transfer evidence, and real-time RTI submissions are the four things that make an arrangement defensible under enquiry.
Frequently Asked Questions
Does my spouse need a formal employment contract if they only work a few hours a week?
Yes, and the hours involved do not change that. Every employee is entitled to a written statement of employment particulars from their first day of employment, and for a family employment arrangement the contract also serves as your primary evidence of a genuine commercial relationship. A short signed document describing the role, the hours, and the rate of pay takes very little time to produce and does considerable protective work if questions are ever asked. The absence of any contract is one of the first things an HMRC officer will note when reviewing the arrangement, because it is consistent with something that was never properly structured as an employment in the first place.
What if I pay my child in cash without running payroll?
It is one of the more common and more costly mistakes in this area.
Cash payments to a family member without a corresponding payroll run are not compliant with PAYE rules, and the pattern of cash wages within a family business is a known red flag that HMRC compliance teams are specifically trained to identify. Beyond the legal exposure, cash payments are the hardest to evidence: if the deduction is challenged, there is nothing to show that the money was paid at all. Running payroll correctly, with bank transfers and RTI submissions, takes minutes with modern software and provides complete protection. Running it in cash removes all of that protection while adding nothing that a legitimate arrangement would not already have.
Can I pay my family member above the market rate to extract more money from the business tax-efficiently?
No. A salary above the commercial rate is likely to be challenged, and if HMRC concludes the excess was not wholly and exclusively for business purposes, the excess is disallowed. The company then pays corporation tax on profits that include the disallowed amount, while the family member continues to pay income tax on the full salary. Both parties bear a tax cost from the same excess payment. The commercially appropriate rate is also the tax-efficient rate.
My child is 15. Can I employ them in the business?
Children under school leaving age can work in limited circumstances, but the rules are specific and vary by local authority. Employment permits for under-16s are issued by councils, and the type of work, the hours, and the conditions are all regulated. The minimum wage does not apply below school leaving age, but payroll and RTI obligations still apply to any payment made. For most owner-managed businesses, the administrative complexity and the relatively modest tax benefit make formal employment of a child under 16 more trouble than it is worth. Waiting until the child is 16 simplifies the position considerably.
Do I have to enrol a family member in a pension if they do not want one?
If they meet the auto-enrolment criteria, yes.
The duty is on the employer, not the employee, and it cannot be waived by a verbal understanding that the family member is not interested. The family member can opt out after being enrolled, and if they do so within the first month their contributions will be refunded. But you cannot simply not enrol them because they have indicated informally that they would prefer to skip it. Failing to enrol an eligible worker is a breach that carries fixed penalties from the Pensions Regulator, and the family relationship provides no exemption.
What happens if HMRC disallows part of the salary?
The disallowed portion is added back into the company’s taxable profits, increasing the corporation tax liability for the year in question. At the same time, income tax and National Insurance were already deducted and paid on the full salary by the family member, because the full amount was employment income regardless of whether the company received a deduction for it. The result is a tax cost at both company and individual level from the same payment. HMRC may also charge interest and penalties where the disallowance reveals an underpayment of corporation tax, and none of that is recoverable. Setting the rate correctly from the outset, documented with a clear commercial justification, is the only reliable protection.
Can I pay my spouse a salary and also pay them dividends as a shareholder?
Yes, if they are both an employee and a shareholder, and the two arrangements are clearly separated. The salary is payment for work performed. The dividends are a return on the shareholding. Both can coexist without difficulty in most cases.
The risk with dividends arises under the settlement legislation, which HMRC can use to attribute dividend income back to the working spouse where the shareholding appears to have been created primarily to divert income rather than to reflect a genuine ownership interest. For arrangements where the spouse is a genuine participant in the business in both capacities, the risk is lower, but the shareholding structure and dividend policy should be reviewed together with your adviser rather than assumed to be straightforward.
Does employing a family member trigger IR35 or any other anti-avoidance provision?
IR35 applies to off-payroll working through an intermediary where the engagement would otherwise look like employment. A family member employed directly by your company and on your payroll is not an IR35 situation. The relevant anti-avoidance provisions for family employment are the wholly and exclusively test on the salary deduction and the settlement legislation in relation to dividends. Both are addressed by getting the rate right and structuring the arrangement correctly from the outset, not by any separate anti-avoidance analysis.
My family member has stopped working in the business but is still on the payroll. What should I do?
Remove them immediately and submit a leaver notification through RTI.
Continuing to pay a salary after the work has stopped is a compliance failure, and any salary paid after the employment ended is not deductible as a business expense. If the payments have continued for some time, the position needs to be reviewed with your accountant to understand the tax exposure and whether voluntary disclosure to HMRC would be appropriate. The sooner it is corrected, the more contained the problem remains.
If you are thinking about this for your own business
Family employment is one of those areas where a conversation before the arrangement starts saves a disproportionate amount of time and cost later. The questions about rate, documentation, auto-enrolment, and whether the Employment Allowance is now available to your company are all answerable quickly once someone has looked at the specific situation. The problems, almost without exception, arise when those questions were not asked at all.
The team at Xeinadin Richmond works with owner-managed businesses across Richmond, Twickenham, Kingston, and the wider South West London and Surrey area on exactly this kind of practical planning. If you are considering bringing a family member onto the payroll, or if you already have and want to be confident the arrangement is properly structured, we are happy to take a look. There is no pressure and no obligation in getting in touch.
About the Author
Donovan Crutchfield, ACA – Area Managing Partner, Xeinadin Richmond.
Donovan Crutchfield is Area Managing Partner at Xeinadin Richmond and founder of TaxAgility. He is ACA-qualified and has worked with owner-managed businesses, professionals and growing SMEs across Richmond and South West London for many years. His practice focuses on helping business owners make clear, well-informed decisions, particularly in areas where the rules are less straightforward than they first appear.
Connect with Donovan on LinkedIn.
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