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Business Information IR35

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For many years, people leaving jobs to become self-employed were advised to instead set up one man companies to provide their services. One reason for this might be the security offered by limited liability, but in many cases the use of a 'personal service company' was to create the opportunity for some quite substantial savings, particularly of national insurance contributions (NICs).

Consider John and Mark, who have for many years worked as managers in a local professional business. They have, until now, each been paid a salary of £48,000 pa. In 2003/04, each would pay income tax of £11,628.80 and primary Class 1 NICs of £4,771.80. In addition, their employer would pay secondary Class 1 NICs of £5,552.64 x 2 = £11,105.28. So, at a cost to his employer of £53,552.64, John would receive £31,599.40 net. Likewise Mark.

John and Mark decide to become self-employed. John finds office accommodation and begins to build up his own client base. Mark instead arranges to work for different firms - say mornings for one and afternoons for a second. In the first case, there is little doubt that John's change to self-employment would be genuine, but in the second there is a strong case for saying that rather than having become self-employed, Mark in reality has two jobs, and PAYE tax and NICs (both primary and secondary) are payable.

The rules for people like John and Mark have existed for many years, and you can read more about them on our webguide 'Employed or self employed?' As you will see, the tests for deciding whether someone is accepted as self-employed for tax purposes are a little vague, but if Mark in reality has what amount to two part-time jobs, the mechanics exist for him to be classified as an employee of the two firms he works with, and for PAYE to be operated accordingly. The effect of all this is for extra costs, in the form of primary and secondary Class 1 NICs to be payable by Mark and his employers.

A Possible Solution

To avoid this, Mark could in the past have set up a limited company, and contracted for the company to provide his services to the two customers. Mark would then have been both the owner of, and an employee of, his own personal service company. He could then choose to take part of his remuneration in the form of dividends - with scope for a substantial increase in his income.

Assume that Mark's company has profits, before Mark takes any salary or dividends, of £53,522.00, and that he takes £7,200 in salary and the balance of the profits, after tax, in the form of dividends.

First, we need to consider the company's tax position - the company will have to pay Mark his salary and secondary Class 1 NICs of £330.24, but the remaining profit will be charged to corporation tax - amounting to £8,555.23. On this basis, Mark can take net dividends of £37,466.53 - plus, of course, his salary of £7,200.

Mark's tax position for 2003/04 would be:

The aim of the IR35 legislation is to stop people who, if they were claiming to be self-employed would in fact be re-classified as employees with all the consequences for primary and secondary Class 1 NICs, using an intermediary. This intermediary being in the form of a personal service company or a partnership to obtain a tax advantage over other workers.

IR35 achieves this by forcing the company to operate PAYE in respect of an amount of notional remuneration, being basically the difference between the company's profit on work caught by the IR35 rules and the remuneration drawn by the owner-director in respect of that work. For more details, and an example of the calculation of notional remuneration, see our separate webguide on personal service companies.

Of course, on the facts, John will not be caught by the IR35 rules, and could set up a limited company through which he can operate his business. For more details on the pros and cons of running your business through a limited company.

Operating his business through a limited company could save John over £2,200 compared with operating as a self-employed sole practitioner.

• Who is caught by these rules?