Do contractors have to fire their wives or husbands?

Do you have to fire your wife or your husband? With the Treasury's new proposals on 'income shifting', it may no longer pay to have your spouse involved in your business.

The End of Small Business As We Know It

It used to be that you started a small business, and your whole family helped you to make the business work. Wives and husbands worked alongside you, even if they didn't actually make money, they helped you with the thousands of details that running a business entails.

Now, if you work with your wife or husband, and that person doesn't make much money, or contribute to the bottom line in some specific, yet-to-be-defined form, then contractors face losses of about 10-12% of their income--up to about 7000 pound per year.'' Check out our calculator to see what it could cost you.

So suppose you are the big earner; you provide the main service that your company offers? Does that mean that your spouse doesn't play an important role? Very often, the spouse does all the stuff so that the big earner can go out and earn. The spouse also sometimes helps with sales, marketing, the Web site, does the books, drives you to the job site, talks up other clients while you're busy with a given job...need we say more?

Nonetheless, this genuine partner in your business won't be allowed, any longer, to share dividend income from the business with you. You will have to take all the income yourself, and pay the highest tax rates on it. It probably won't even be worth your while to pay your spouse a salary any longer.

"We are seeing the end of all the benefits of running a small business as we used to know it," says David Colom, head of the London-based chartered accounting firm DJ Colom & Co which specialises in contractor affairs.

Revenge for Arctic Systems

The real history of all this goes back a few years, when key functions at the Treasury and the Revenue were combined. The Treasury has been pushing the Revenue since then to find ways to stop tax avoidance and to get more money out of us all. Which is only fair; it's their job.

In this context, the Treasury has launched a series of attacks against the contracting industry. The notion behind it is that companies are using contractors instead of employees to save on tax--the unions don't like this of course either. And contractors are using the limited company form to avoid tax too.

There has been a lot of abuse of this kind, and we all know it. The problem is that it's not just contractors who are at fault; since 2004 all of the experts and organisations have been crying out for a full review of small business taxation. It's not just contractors--it's the whole system that needs to be revised since the laws date from before the Internet or to some other equally prehistoric period.

Instead, the Treasury is determined to tweak the law we have, and the result has been a pickle. We have had IR35, the managed service company legislation, and now 'income shifting.' This last one is a thorn in the Treasury's side: because the Treasury and the Revenue lost a court case against a contractor company called Arctic Systems which tried to attack this "income shifting.'' With the support of the Professional Contractors Group, Arctic Systems spent six years fighting the move, and won for good this year.

What Is ''Shifting?''

"Income shifting" supposedly occurs when both spouses work for a contractor limited company. Colom explains: ''One member of the couple is engaged in a particularly lucrative activity; the other has a different role, perhaps keeping the books, managing the company, or just earning a great deal less than the other partner. Each member of the couple earns dividends in proportion to the amount of ordinary shares they have in the company, and so a certain amount of the income is placed in the hands of the low-earning spouse, who enjoys a lower tax rate.''

(You can only do this if the spouse has ordinary shares--any other kind of share won't be accepted).

Colom reminds us that the highest amount that works with this strategy is GBP 38,000. If you earn more, you won't get the benefit.

''Extremely Disruptive''

''It will be extremely disruptive for the industry,'' Colom points out. The law will not apply to companies publicly listed on stock exchanges--here there are lots of shareholders who make no contribution to the company yet they earn dividends.

Most experts think that the Treasury will not be able to make this clear, and that the result will create chaos for small businesses who try to comply with it. Still, it will probably go through, and another blow will be dealt to the contracting industry in the UK.