Cash in hand can cost a packet

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However uncomfortable Iain Duncan Smith may be finding life at present, the scrutiny of political expenses is to be expected in parliamentary life. It is only two years, for example, since Henry McLeish, the former Scottish First Minister, resigned because his constituency expenses had got into a "muddle". In ordinary life, domestic arrangements are increasingly subject to regulation and fiscal enquiry, be they income from family companies or cash payments to domestic staff. The basis on which you engage home-based workers such as cooks, nannies and secretaries can also open a Pandora's box of civil and criminal liabilities.

Demonstrating zero tolerance towards even petty financial scams, the Inland Revenue is cracking down on tax-evasion schemes involving small companies. One legitimate method for saving tax is to employ spouses as secretaries. David Convisser, tax partner at the chartered accountants Gerald Edelman, says: "The Inland Revenue has in recent months been looking closely at situations where a small family company, the shares of which are owned by husband and wife, is in effect run by the husband, who is the income-generator for the company, the wife having no other income. If the company pays out dividends to the wife, the level of which do not reflect her capital investment or her work, then these arrangements will be challenged by the Revenue. It will [in that case] view dividends as being paid to save tax by using up her basic-rate band, and will instead assess the husband on the dividend income directed to her. If she is remunerated fairly, either by dividend or by salary, for work she has carried out, that is acceptable."

On 8 October, Dame Elizabeth Butler-Sloss, president of the High Court's Family Division, gave a ruling in the divorce proceedings P vs P that impacts on the black economy. She found that lawyers must disclose to NCIS information concerning "criminal property" as defined by the Proceeds of Crime Act 2002. Designed to counter money-laundering, this legislation could cover humdrum tax evasion. In Dame Elizabeth's view: "An illegally obtained sum of £10 is no less susceptible to the definition of 'criminal property' than a sum of £1m." In ancillary relief applications, this probably means untaxed income rather than proceeds from the Great Train Robbery. Prima facie, the same principle applies to everyday sums paid to household staff.

Should we, then, worry about how we pay domestic staff, and are we complicit in tax fraud if we pay them in cash? Is it different if someone works part time? According to Convisser, "Depending on the working relationship between householder and worker and the nature of the duties carried out, both full-time and part-time staff could be regarded as employees, with the result that the householder should deduct NI and PAYE before paying salaries - that is, the employees should receive net pay." "Nanny tax" is merely jargon for "a term to cover nannies being employed". A finance director of the niche law firm Plexus Law suggests that "if staff have taxable pay and benefits of less than £160 a week, you can use the Inland Revenue's Simplified Scheme for accounting for tax and NI. The Revenue will send you a pack designed to help you to calculate the tax and NI very easily." However, non-accountants may find tax computations daunting, and many staff earn more than this amount. Accordingly, firms such as Gerald Edelman administer schemes for paying domestic staff.

The employment-law specialist Barry Stanton suggests clarifying employment status at the outset. He warns: "There is no one test to identify who is an employee. It is easy if there is a formal, written contract. If an individual is not working full time for one employer, then the issue arises of whether they are a worker or a self-employed contractor. Where work is ad hoc - for instance, gardening - then the risk of a finding that someone is an employee is lower, but if it is a regular visit, it may constitute an employment relationship, particularly if all tools are provided for him."

Matthew Tom, an employment lawyer with Tarlo Lyons, says that being the sole employer is a key factor. Here, "where a domestic worker works full-time for a single household and remains under the household's day-to-day control, he or she will normally be deemed to be an employee of the household."

It further complicates matters that there are regular part-time workers. Tom believes that "household workers such as cleaners, nannies, au pairs and cooks will generally fall into two areas of legal definition, being either independent contractors or employees. Workers who attend the home on an intermittent basis and who work for a number of clients will generally be classed as independent contractors who are in business on their own account."

It is important to remember that employee rights include basics such as the national minimum wage, holiday and sickness benefits and statutory notice periods. Less obviously, Stanton cautions that "a more alarming prospect arises if the nanny gets pregnant." She could be entitled to 26 weeks' maternity pay and 13 months' leave. You would have to fund a replacement and hold the position open for her. Accommodation, if part of the job, could become contentious unless it is made plain that it forms part of remuneration. However, there is a risk that she could remain in her "nanny flat" for 13 months. Tom adds that redundancy may have to be paid if you move home.

Employees may also bring their grievance to an employment tribunal. Stanton refers to a recent employment appeal tribunal case, XXX vs (1) YYY and (2) ZZZ (2003), in which a nanny brought a claim for sex discrimination against her employers, alleging sexual advances by her charge's father, a claim denied by his parents.

Another compelling reason to ensure that the employer-employee relationship is clarified from the outset involves the need for client confidentiality. Lady Archer encountered this problem and ended up going to court. She sued her former secretary, Jane Williams, because Williams wished to disclose information learnt during her employment. Lady Archer won the case, but not before a number of damaging revelations had been published..

The barrister Rambert de Mello, who specialises in human-rights cases, represented Ms Williams in court. He comments: "The starting-point with nannies, like private secretaries, is that they are people who occupy a position of utmost trust, and you need to have the confidence that they will retain their discretion." Anyone based in your home becomes "the eyes and ears of the employer; they answer the telephone, meet visitors, may have access to bank statements and diaries and learn personal information, for example about medical conditions. The doctrine of equity would assist even in the absence of a contract." Accordingly, they might be deemed to owe a duty of confidence, but "it is preferable to have an express restraint not to disclose, directly or indirectly, private matters to third parties. The categories of information could be detailed to avoid misunderstandings."

A spokesperson from the North London Nannies agency, an established London agency, says that they "believe firmly in the value of contracts to protect both parties". They "have seen many stumbling-blocks over the years that would easily have been sorted out if people had sat down together and worked out a mutually agreeable contract." Typically, "problems arise when a desperate employer offers the moon at interview, and then a nanny finds extra workloads that have never been discussed, longer working-hours appearing from nowhere, or even an extra child on the scene. A partnership of mutual respect, one within which the nanny's employment rights will be honoured, is usually the one that endures."