It is not illegal to set up a private company to receive fees. Tax savings and flexible pensions are the undoubted benefits but it's an option only high-earners should consider.
Aside from holding some of the top jobs in the British media, John Birt, director-general of the BBC, Martin Sorrell, chief executive of WPP and Michael Green, chairman of Carlton Communications, have something else in common. Each of them has, at some time, been paid as a consultant and run his earnings through his own private company.
Of the three, Birt's affairs have attracted the most attention - to the extent that, in the wake of the furore that followed this revelation, he now pays tax under PAYE along with the rest of us. Still, why do so many of his peers set up such arrangements?
'It's not uncommon in the media and entertainment world and other areas where people either change employers regularly or have expertise with a limited shelf life,' explains Moira Elms, personal financial planning partner at Coopers & Lybrand. 'The main advantages are greater flexibility for both the employer and the consultant, and the ability to provide better benefits - pensions, in particular. Employees can lose out on pensions if they change jobs regularly, but they can create continuity of employment by running their own company.' But, as Elms also points out, the Inland Revenue tends to study these arrangements closely if it looks as though someone really ought to be on PAYE.
Contrary to popular perception, there is nothing illegal or disreputable in setting up a private company to receive fees. There are, however, some obvious constraints. Like the self employed, anyone taking this route will generally need to have more than one source of income or a series of short-term contracts if he or she is to avoid being viewed as essentially a PAYE employee. The Revenue will also expect persons setting up a company to make their own pension, life assurance and sickness benefit arrangements. The key here is to have a contract for services rendered rather than a 'contract of service' which means that the employer controls what is done and when. In John Birt's case, if he had not volunteered to become a full-time employee of the BBC it is likely that the Inland Revenue would have investigated more closely whether he truly acted as a 'consultant'. He apparently had no income from other sources. Neither was he on a short-term contract.
According to Elms, 'It isn't really worth doing unless your income is at least £100,000 and you don't need it all for day-to-day living expenses'. There is also no point, she says, in running your own company and charging yourself out as a consultant if you need to pay all the earnings to yourself under PAYE as an employee of your firm.
For high earners the arrangement can have a number of tax advantages. Profits accumulating within the company will only be subject to corporation tax at the small companies rate of 25% - rather than the 40% top rate of personal taxation - if they remain below £300,000 pa. Pay can also be taken in the form of dividends rather than salary which avoids National Insurance contributions. Further, all expenses incurred in carrying out the consultancy can be charged to the company. Those who intend to retire abroad can thus avoid tax by letting cash accumulate within the company, becoming non-resident for tax purposes, and then paying a huge one-off dividend to themselves once they are safely overseas.
But the most common reason for setting up this type of arrangement has more to do with pensions and benefits such as 'death in service' lump sums. For the employed and self-employed there is a limit to the amount that can be paid into a pension scheme. The funding arrangements for executive pension plans (EPPs) or small self-administered schemes (SSASs) run through a company are more generous. Often all the surplus not taken from the company as salary can be transferred into an EPP or SSAS, thereby avoiding tax quite legitimately. Birt, for example, was reputedly paying £35,000 a year into a pension scheme. Had he been self-employed with a personal pension he would not have been able to do so because of the 'cap' on earnings eligible for pension tax relief (currently £78,600) and the contribution limit of a maximum 40% of eligible earnings.
Those who choose to run their own companies can employ other members of their families, a partner or spouse or grown-up children and keep all of their salaries below the threshold for higher rate tax. They, too, can all be members of the pension scheme. Members of the family can become shareholders and be paid dividends rather than income, which, again, avoids National Insurance contributions.
'There are advantages, too, for the company which employs people as consultants,' says Elms. 'It's often done with high-flyers where the cost of providing a pension would be enormous, or in companies with a very rigid salary structure to avoid creating precedents or stirring up resentment.' WPP explains that Martin Sorrell's pay arrangements had been set up in 1987 and enabled the company to avoid National Insurance and pension contributions. Elms also points out that 'you might want to employ someone on a short-term contract - it is common, for example, in the computer industry or in management consultancy. It is much easier for a company to hire and fire someone on a short-term contract where they cannot sue for unfair dismissal.' But there are certain disadvantages. It will cost at least £300 to set up the company.
More important, there will be ongoing accountancy costs of at least £1,500 a year, possibly as much as £3,000. Those considering taking this route should first make sure that the tax savings and pensions benefits make it worth their while.