Why should entrepreneurs have service agreements with their own companies?

May 1, 2013

For many entrepreneurs, putting in place an employment contract or service agreement between themselves and their own companies is an alien concept. It isn’t until there is external equity investment in the business that there would seem, to them, a need to do so. However, here are five reasons why it is sensible to properly record the terms on which the entrepreneur is engaged.

1.    Certainty of pay and reward
You will obviously be expecting your business to grow and be successful, so why not ensure that your remuneration provisions allow for you to be properly rewarded in such circumstances? If the provisions are set out early on, it is more difficult for others to water them down if you need to bring in more shareholders.

Equally, what if it goes wrong and you are pushed out of the business by your business partners? The agreement can include set termination payments and the like to ensure that the owner/manager is properly compensated and not solely reliant on their shareholding.

2.    Status
Whilst there might be more tax efficient ways of being remunerated, clarifying your status as an employee of the business (as well as a director and majority shareholder) can have certain benefits.

For example, in the case of Clark v Clark Construction Initiatives Limited,  Mr Clark was the founder and majority shareholder in a company. As the business grew, his business partner (Mr Grew) also took a shareholding and eventually took control of the day to day running of the operation. Mr Clark and Mr Grew fell out, and Mr Clark was dismissed. The company defended the unfair dismissal claim on the basis that Mr Clark was not an employee of the company, and the case involved a detailed analysis of Mr Clark’s working arrangements in order to determine his status. Mr Clark’s position would have been much more straightforward had he been working under a written contract of employment.

Similarly, if a start-up is not successful and the business becomes insolvent then the founder is likely to be in a more favourable position as an employee, for example he might be able to claim a redundancy payment and notice monies from the National Insurance Fund.

3.    Tax
There may be some benefit to individuals in receiving a salary from the company in an amount up to (or just below) their personal allowance.

Payments of salary to an employee or director of a company are generally less tax efficient for the individual than receipt of a dividend, being subject to income tax (at potentially higher effective rates) and both employer and employee national insurance contribution; though the company will usually obtain a corporation tax deduction for any salary paid to an employee or director of a company, as well as in respect of employer national insurance contributions. There may be an overall advantage in paying a tax deductible salary, where the relevant income is at a level at which no income tax and only a small amount of national insurance contributions will arise.

It is a common misconception that a consultancy arrangement, whether directly with the individual or through a personal service company owned by the individual, will prevent an individual from being subject to the PAYE system and possibly improve their position with respect to incurred expenses (e.g. travel expenses). This will not always be the case, particularly where in reality the individual is an employee or executive director of the company. In those circumstances, where the director is also paid the consultancy fee indirectly through a personal service company, the PAYE obligation, including in respect of employer’s national insurance obligation, will fall on the personal service company. Therefore, in many such cases it may be more advantageous for an entrepreneur to be employed directly by the company, as such arrangement will bring certainty to the tax position and avoid the risk of unnecessary tax enquiries, or unexpected tax liabilities (potentially with interest and penalties) arising.

4.    Setting an example
When it comes to recruiting employees, it ought to be easier to persuade candidates to sign employment contracts if you can give them the assurance that you have signed a contract based on the same template and that certain terms are fixed for all staff. This should cut down the amount of time spent negotiating terms, and therefore overall legal spend.

5.    Encourage investment
Many external investors will want to see the owner/manager’s employment document as part of their due diligence exercise. Some larger investors might delay their investment until appropriate contracts are in place with key men, and so the administrative process can be reduced by having taken early steps to show that your business is well organised.


Related pages:

Business Start Ups more

Experts on the human side of enterprise more

Tax and Incentives more

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