Make sure your nanny won't land you in jail

Richard Murphy outlines a scheme for keeping parents solvent - and out of prison

Parents who pay their nannies cash in hand could be jailed for up to seven years and fined up to£5,000 following a change in in the law.

No one knows quite how many nannies there are in the UK, because so many are paid in this way. Most nannies negotiate their salaries in net terms, preferring to leave the payment of any tax and National Insurance to their employers, the parents - and they have often failed to pay some or all of the income tax due to the Inland Revenue.

But from 1 January, paying an employee cash without handing over the proper tax to the Inland Revenue became a criminal offence.

The most common way to pay tax on behalf of a nanny has been through Pay As You Earn (PAYE). This has proved expensive for parents, who receive no tax benefits or reliefs - any payment comes out of the employer's taxed income. A nanny earning £225.80 net a week, £11,742 a year, will incur £2,153 income tax and £1,105 employee's National Insurance, making a total £15,000 a year. In addition the parent has to pay a further £1,297 of employer's NI, making the total cost £16,297. The table shows how this works.

Now, however, there is an alternative and legal way of making the payment - and saving money.

This may be the time to set your nanny up in her own private limited company. The Revenue has been attacking most 'personal service companies' - companies owned by one person and supplying all their services to one customer. But the law that does this also makes it clear that if the company supplies services to someone who is not in business, such companies are quite legitimate. Parents are not in business as parents, so a nanny can be a one-person personal service company.

In addition, last October it was also made clear that minimum pay legislation does not apply to directors of their own companies who have no contract of employment. This means a nanny who has her own company is free to set her own pay rate. This is very important in this alternative payment plan.

So how does it work? First you have to set up a company. As you will have to use an accountant to work this scheme, you may as well buy the company from your firm of accountants. This and all accountancy fees should cost no more than about £1,200 a year. Your nanny has to own this company and be a director, but one of the parent employers should be company secretary.

They can then take responsibility for the administration. (You have to be realistic here: your nanny may not be too keen on this part of the job.)

Once the company is set up, it bills the parents for the nanny's services. The amount billed should be just enough to cover all its costs. Using the same example as before, this total is £13,767. If you want to keep admin to a minimum, levy bills quarterly in advance. This would make each bill £3,441.75. State on the invoice that fees are not refundable. It is critical that paperwork such as invoices is done. If it is not, this scheme could be challenged as a sham, which it is not when done properly.

Your nanny's salary will now comprise two parts - salary and a dividend, both paid by the company. The salary should be just enough to make sure your nanny has an NI credit. If she is paid £83.50 a week, she'll pay no tax on the salary and NIof just 75p. There is no employer's NI. The net pay is £82.75. The annual cost is £4,342. She now needs another £142.25 per week, or say £7,400 a year. This can be paid as a dividend.

Companies that make less than £10,000 of profit a year pay 10 per cent corporation tax. A dividend has a 10 per cent tax credit attached to it and a basic-rate taxpayer (which the nanny will be) pays no additional tax on receipt of a dividend. So, the company has to have profits after 10 per cent tax of £7,400, which means pre-tax profit is about £8,225. This is used to pay the dividend and the nanny pays no tax at all on it.

Now the company has three costs: the profits to pay the dividends, the salary and the cost of running it. These amount to £8,225, £4,342 and £1,200 respectively or a total of £13,767. Paying the same nanny under PAYE costs £16,297, so the saving could be £2,530, after costs. This is summarised in the table above.

You will need some help with this. Bills have to be raised, dividends have to be paid and recorded properly, and the company will have to prepare and file accounts. So you should consult an accountant. But the scheme is legal and cost-effective at a time when there will be a clampdown on 'cash in hand' nannies. It has to be worth considering.