Let's start by looking at the potential tax advantages, using 2003 figures. At its simplest the aim is to ensure that your spouse receives tax-free income of about £4,600 per year.

This could save the family anything from £1,015 to £1,840 per year if the money would otherwise have been part of your taxable income. The income would only be tax free if it falls within your spouse's personal allowance for tax purposes. This assumes therefore that your spouse does not have any other taxable income.

Let's look at the position of Gordon and Sarah, who are both involved in the family business. Gordon is the "main man" but he relies on Sarah's support and assistance to enable him to operate effectively. She doesn't have any income of her own.

Gordon earns about £30,000 per year, but doesn't currently pay Sarah anything for her contribution to the business.

After all they live together and both spend the money that Gordon earns. What difference would it make?

Well, in round sum terms, Gordon's tax bill on his earnings of £30,000 will be about £5,350. If, he paid Sarah a salary of £4,600 then his tax bill would fall by about £1,200 but Sarah would have no tax to pay on her £4,600 salary. This is because it falls within her personal allowance. As a family they would save £1,200 a year (at current rates).

Additional tax savings could be possible if Gordon was subject to tax at 40%. He might be able to redirect further income to Sarah who would pay tax at lower rates on anything up to £30,500 in addition to the £4,600 noted above. The maximum tax savings in such a case are over £7,500 per year.

If you are in business you too could achieve this - in one of three ways depending upon the type and structure of your business: Paying a salary for work done by your spouse; or paying a dividend on shares owned by your spouse; or sharing profits with your spouse (in a partnership).

There is another benefit to some of these arrangements too. If your spouse is paid a salary of between £4,004 and £4,615 and has no other earned income then no National Insurance Contributions will be due. However even a salary at this level will count towards state retirement pension and state benefits.

Tax Traps

Sounds good doesn't it? So what could go wrong?

Well, if the Revenue suspect a "fiddle" there will be back taxes, interest and penalties to pay. The total could easily mount up to something between £40,000 - £50,000 over a six-year period.

Clearly it's important to minimise (or even eliminate) the prospect of such a problem. The way to do this is to do things properly. Don't take short cuts. Don't get greedy and don't try to rearrange things without taking professional advice.

Real work

If you pay a salary for work done by your spouse it is important that the work really takes place. The Inland Revenue may seek evidence to prove that your spouse was working in the business, so you need to keep good records to evidence the work done and hours worked each week.

Dividends are paid to shareholders so there is no need for any work to be done in return for the receipt of dividends.

Partnership profits need not be shared by reference to relative contribution or work. However, for reasons explained later it is best if both partners are actively involved in the business.

Real payment If you are a sole trader, or if your business is carried on through a company, you will want to pay your spouse up to £4,615 (2003/4 tax year). You can then deduct this from your taxable profits. But you do need to be able to evidence the fact that the payment has really been made.

You should not expect the taxman to accept your claim to tax relief for salary payments that you haven't actually physically paid to your spouse.

Cheques are probably the best way to ensure there is evidence of payment, both of salary and of dividends.

Partnership profit shares will be reflected in the business accounts and drawings should be paid out separately to each partner.

Keep the paperwork

Dividend payments should be recorded on "vouchers" that your accountant can probably supply. Dividends should also be properly voted and recorded in the company's minute book.

Again your accountant will be able to help here.

Salary payments should go through a PAYE scheme even if no tax is payable and the annual forms should be retained for tax purposes.

Partnership profit shares will be reflected in the accounts.

Avoid a "settlement".

In April 2003 the Inland Revenue announced that it did not approve of settlements between husband and wife (or between other family members).

This specifically affects situations where one person gains a tax advantage by making a gift which is principally a "right to income".

The taxman is specifically concerned with situations where they believe there is an arrangement to divert income from one spouse to another.

This means there could be a problem in some cases.

For example, when shares are given to a spouse and the main earner then draws only a low salary so that enhanced dividends can be paid to someone else. This is especially true when there is little capital value to the business.

National minimum wage If your spouse works for your company you should be paying at least £4.50 per hour (£3.80 if your spouse is under 22 years of age).

This rule does not apply to dividend payments or if you are a sole trader or in partnership. It also does not normally apply if your spouse is a director of the company.

All the tax and NIC advantages noted above apply equally where the two people are not married. So don't feel you have to miss out if you're not married to your "partner".

Of course the tax traps are still there to be avoided.