In good company

Number crunchers at the Institute of Fiscal Studies say self-employed workers are likely to blow a large hole in the government's finances as they switch en masse to incorporate themselves as small companies following changes announced in the Budget.

The well-respected think tank said in a report this week that tax breaks introduced in the Budget could be used by 1.2 million of Britain's 3.8 million self-employed people to save on average £500 on their tax bills. Someone with profits after expenses of £15,000 will save almost their entire £2,800 tax bill. The result could cost the government in excess of £2.5bn over the next four years, says the IFS.

"We don't expect people who are only going to make a marginal gain to take this up, but there are significant benefits for a sizeable number of people who have profits and pay tax at the moment," says one of the report's authors, Julian McCrea.

Already, accountants are reporting a rush of self-employed workers making appointments to examine the benefits for their businesses.

John Whiting, president of the Chartered Institute of Taxation, says members of the institute, many of them with small high street practices, have been deluged with calls from clients asking for details about adding Ltd to their name.

Richard Shooter has also been busy in recent weeks. Mr Shooter is head of the small practitioners committee at the Institute of Chartered Accountants in England & Wales and says there has been a frenzy of activity building up since the Budget.

"People are getting carried away with the idea of becoming a company. They see the tax advantages and nothing else which means it looks very attractive," he says.

You can take it from Mr Shooter's remarks he doesn't believe that becoming a company is straightforward.

There are four main tax breaks that favour small companies. You can take part of your income in the form of dividends. This is allowed because you are not only the company's sole director and employee, but also the owner and therefore sole shareholder. The chancellor gives a tax credit on dividend payments in small companies that effectively makes them free of tax for standard rate taxpayers.

Dividends also avoid national insurance, which is a boon when you become a company and you are liable to pay employee's and employer's national insurance. The government's announcement that national insurance rates will increase from next April only makes the tax break more valuable.

The next tax break is the new one. The decision to cut the tax on the first £10,000 of profits to zero is supposed to give a helping hand to fledgling businesses that need to keep the cash. But it is open to all small businesses.

Just as significantly, limits on tax breaks for pensions have also been lifted. Before the advent of stakeholder pensions, the amount of money you could shove into your pension was determined by the level of your salary. This rule discouraged the use of dividends. If the limit for your pension contributions is 17.5% of salary then an artificially depressed salary payment severely limits your pension contributions.

Rule changes that came in with the stakeholder end the link with salary, allowing someone on a small wage to make large pension contributions.

These changes have enticed even larger businesses to look at incorporation (see case study).

Mr McCrea says there have been several government tax initiatives that have been largely ignored until finally, after one small tweak to the system, thousands of people take it up. Gordon Brown's tax relief for the British film industry was a classic example. It was then used and abused as a lucrative perk by big television companies.

The warning shot in this instance is that so much tax money leaked to the wrong kinds of business that Mr Brown switched it off at the last Budget.

Mr Whiting says there is also the danger that thousands of people will spend large sums of money incorporating only to see the chancellor cut his losses and change the rules back again. It is one of many problems Mr Whiting and Mr Shooter highlight, together with all the other accountants who spoke to Jobs & Money this week.

"While it it is true that for the first time the jobbing decorator who makes £15,000 a year will pay no tax if he becomes a company and puts the money through the company, there is more to it than that," says Mr Whiting. "Managing a company is more complicated than simply producing a tax return for the Inland Revenue when you are self-employed."

There are set-up costs that can run into hundreds of pounds. You can buy a company "off the shelf" for as little as £100, but it is more likely to cost between £200 and £400. There will be accountants' and lawyers' fees to pay on top.

Ongoing professional fees are also likely to remain £400 to £500 higher than the usual £200 to £300 bill charged to a self- employed worker for processing a tax return, which you must still fill in each year.

Mr Whiting says that expenses, especially those in the home such as heating and lighting, can be harder to claim for a company (they must be wholly, exclusively and necessarily for the business rather than just wholly and exclusively).

There is more paperwork when you produce company accounts, which you must send to Companies House each year. As an employee you must be paid through a PAYE system. Not only does this create even more paperwork, but also it forces self-employed workers to pay tax as they go rather than twice a year in January and July.

Mr McCrea dismisses these administration costs as small beer compared to the tax benefits offered by the government.

"We have relatively simple rules for setting up a company. So I don't believe there will be huge start-up costs and the ongoing cost of advice from professionals won't be as significant as some people say. Filing returns to Companies House is not that onerous - the information is pretty minimal," he says.

"Not everyone will want to do it, but I'm not surprised there are lots of people saying that they want to save £2,000 to £3,000. It's a lot of money."