Supply teachers who try to avoid paying tax by forming limited companies are playing a dangerous game, according to specialist tax consultants.

“Such schemes can destroy friendships, and teachers could also end up facing a huge bill if the Inland Revenue decides that their company is not a genuine business,” warns Angela Beech of IE Taxguard, a firm of personal advisers.

Leading supply agencies such as Capita, Protocol and Hays International offer “limited company status” to teachers on their books so they can cut their tax bills by receiving some of their pay in dividends. A teacher earning pound;26,000 could pocket an extra pound;2,800, after paying a 5 per cent commission to a finance company - often an offshoot of the agency.

The benefits to the agencies are huge, says Ms Beech. “They avoid paying employers’ national insurance of around 11 per cent, and they don’t have to pay sick pay or holiday pay; it’s a great way to get cheap labour.”

But company schemes could cause all sorts of problems for supply teachers. The Inland Revenue is likely to use rules introduced in 2000 to prove that the companies are not real businesses, say experts. Teachers might then end up having to pay back all the tax, and the employees’ and employers’ national insurance contributions.

The IR35 rules were brought in to close a loophole that was being exploited by computer programmers. After being made redundant, the programmers would return to work for the same company, doing the same work but with limited company status. This saved the firm millions in pensions and national insurance, and slashed the programmers’ tax bill, as tax was only paid at 10 per cent on earnings declared as dividends.

The Inland Revenue now has a series of tests to assess whether companies are genuine. Inspectors might ask: would revenue be increased if the business took risks or got the job done more quickly? Who supplied the equipment so that the work could be carried out? Was the company able to substitute supply teachers for each other?

Ms Beech believes that supply teachers could be on sticky ground because, for instance, if a school wanted a physics teacher rather than an English teacher, a small “limited company” is unlikely to be able to offer a substitute. And supply teachers are unlikely to enhance their business reputation by taking risks or finishing lessons early.

Paying dividends could also cause difficulties. Dividends have to be awarded to all directors regardless of how much work they have done, so if a small group of supply teachers have banded together to form a company, those who have landed plenty of work would effectively be subsidising those who haven’t.

Ms Beech is particularly concerned that supply agencies have been encouraging teachers who don’t even know each other to form companies together. She says this could lead to bad feeling if things go wrong.

Another disadvantage is that dividends do not qualify as earnings for the purposes of pension payments, so restricting the amount that supply “companies” can pay into pension plans (you are only permitted to contribute a certain percentage of your salary).

Running the company can also be expensive and time-consuming. Accountancy fees could be as much as pound;100 per month; paperwork will include personal tax records, VAT returns and dealings with Companies House, not to mention invoicing and chasing local authorities for payment. When the company is wound up, capital gains tax may also be payable, based on its dividends.

Ms Beech urges teachers who are forming a group company to take great care with the contracts which are drawn up between the company and the agency.

She says that setting up an individual company might be easier and safer than organising a group.

Here, the advice is to demonstrate that you are self-employed so that you can satisfy the Inland Revenue. Teachers must be able to show, for instance, that they are contacting schools and local authorities themselves to look for business. It is also helpful to earn money in a range of ways: marking exams, taking on extracurricular activities or tutoring would show that you are an education business rather than a supply teacher.

If you are unsure whether your company will be acceptable to the Inland Revenue, the best thing is to ask them. You can approach your local tax office to explain your plans and they will refer them on. Or contact IETaxguard: 0800 9759010, or see www.inlandrevenue.gov.uk