Tax loophole brings more profit online

Kim Thomas discovers a `bit of a scam' which turns IT contractors into companies and saves them thousands

If someone told you that you could earn pounds 60,000 or more a year, pay no National Insurance and avoid the higher rate of tax, you would probably think it sounded at best dubious, and at worst downright illegal. In fact, in the UK today, there are 75,000 people in the information-technology (IT) industry working under a scheme that allows them to do just that - perfectly legally.

These 75,000 people all operate as one-member limited companies. This unusual situation has arisen because of the chronic skills shortage in the computing field, which means that many firms are forced to hire people on lucrative contracts, typically paying between pounds 40,000 and pounds 80,000 a year.

Unlike freelancers in other industries, IT contractors normally work for only one client at a time. They are employed through a recruitment agency to work on a client site, where they are treated, to most intents and purposes, like normal employees, travelling to work every day, working standard hours, and using the client's equipment.

For that reason, the law does not allow IT contractors to be taxed as self-employed. In theory, the contractor should be paid a wage by the recruitment agency, who should deduct National Insurance and tax in the normal way. However, since the early Nineties, most contractors have chosen instead to form one-member limited companies. Instead of the agency paying the contractor, the contractor invoices the agency through the company. The financial savings can be huge.

How does it work?

As a limited company, you cut your tax bill by paying yourself, as a director, a small monthly salary and then taking the rest of your income in quarterly dividends. Your dividends incur corporation tax at 21 per cent (for small businesses with profits below pounds 300,000) but not National Insurance, and you can avoid paying National Insurance altogether by taking a salary of less than pounds 320 a month.

But it gets cleverer. Imagine your company makes pounds 60,000 a year. As an employee earning that amount, you would expect to pay tax at 40 per cent. But as a contractor, you can avoid that by making sure that you pay yourself no more than pounds 30,000 a year in dividends. Still, it seems a shame to leave the remaining pounds 30,000 lying around in the bank. The answer? Make your spouse a shareholder. Your spouse can take dividends of pounds 30,000 and you are still paying tax at 21 per cent.

David Houston, of Houston Rooney, the accountancy firm, acknowledges that it's "a bit of a scam" but adds: "There's nothing illegal about it. It costs the Inland Revenue money and makes their job a bit more difficult but they are powerless to do anything about it."

Interested in setting up a limited company? Here's what you do:

Step 1. Form the company. You should do this through an accountant, preferably one who specialises in one-member limited companies. You can either choose your own company name, in which case the company will take about two weeks to create, or you can pick an existing name off the shelf and start using it straight away. You will be able to change the name at a later date if you want.

As a result of forming the company, you will receive two main documents: A certificate of incorporation (your company's "birth" certificate) which gives your company's date of incorporation and its registered number; and the memorandum and articles of association. These represent the company's constitution and should be kept in a safe place.

Step 2. Appoint a director and secretary. You will normally be the director of your own company. The secretary, who will be responsible for signing your company's financial report, will normally be a close friend or relative.

Step 3. Apply to register for VAT. This is compulsory if you expect your business to have a turnover of more than pounds 46,000 a year. If you expect to make less than that, you can choose whether to register for VAT or not. In financial terms, it is certainly worthwhile, because you can claim back VAT on all purchases you make for the company, such as a new PC, computer software or stationery. It does, however, involve a lot of paperwork and there are penalties for not filing your returns on time.

Step 4. Open a company bank account. Your bank manager will need to see the certificate of incorporation and memorandum and articles of association. You may want to open two accounts, so that you can use one for setting aside money for tax and VAT payments.

Step 5. Set up your accounting records. Your accountant will advise you on how to do this.

And finally, be prepared to accept that all this involves some extra work on your part. You're running a small business now - so keep your accounts in order, file your tax returns on time, and above all, make sure you hire a good accountant.