After you make the move into the world of IT contracting, the first task you need to do is choose which type of business structure to work under – a limited or umbrella company.
Clients work with contractors on a business-to-business basis, so there are several ways in which contracts are actually arranged:
1. Direct Contracts – the contract is made between the client company and the contractor’s own limited company or umbrella company. This arrangement represents perhaps 10% of the contracting market.
2. via Agencies – one contract is made between the client company and the recruitment agency, and another between the recruitment agency and the contractors’ own limited company or umbrella company.
In this guide, we look at the two main business structures used by contractors – the limited company and umbrella company.
If you set up your own limited company, you will typically also become a company director.
As one of almost 1.8 million actively trading companies registered in the UK, you will have a number of statutory and financial obligations; you will have to submit annual accounts to Companies House (the registrar of companies in the UK), run the company solvently and responsibly, and meet your HMRC tax deadlines.
Fortunately, most of the legwork involved in running a company can be taken on by a specialist contractor accountant, although as a director you are responsible for meeting the company’s obligations.
Most contractors operate via their own companies, and there are literally hundreds of contractor accountants in the marketplace who will be more than happy to show you the ropes.
One of the main benefits of contracting via a limited company is that it is the most tax-efficient way to operate.
Unlike a permanent or umbrella employee, you pay yourself in the form of a basic salary (typically low), and the remainder is drawn down as dividends.
Dividends are not subject to National Insurance Contributions, which results in a tax saving, although the extent of this benefit was reduced significantly in April 2016 following an overhaul of dividend tax rates.
As a company director, you also have a great deal of flexibility over when to take income out of the company, which has further tax planning benefits, and you can also benefit by transferring some shares to your spouse (if appropriate).
Limited companies pay Corporation Tax on their annual profits (at a rate of 19%), and VAT is added to all your invoices and repaid to HMRC each quarter, after allowing for any VAT you may have reclaimed on company purchases.
To get started, you will need to form a new company, which is an inexpensive and quick process these days.
You can incorporate directly with Companies House for under £12, although many contractors opt to leave the start-up process to an accountant.
An accountant will also undertake a number of other initial tasks, such as setting up the company payroll and registering the company for Corporation Tax and VAT.
Pros: most tax-efficient way to operate (unless caught by IR35), more control, tax planning opportunities, professional image.
Cons: some administration, statutory obligations for directors, harder to set up than umbrella.
The number of umbrella company schemes operating in the UK has grown rapidly over the past decade – with a sizeable proportion of contractors effectively forced to use umbrellas as a result of the Off Payroll changes from April 2021 onwards (see ‘IR35′ below).
If you join a PAYE umbrella company, you become an ’employee’ of the provider. The client pays the umbrella when you have submitted a weekly or monthly invoice, and you receive a salary after deductions for tax, National Insurance, expenses, the umbrella fee, ’employment costs’ and any other pre-agreed costs such as student loan repayments and pension contributions.
It is not as tax-efficient a business structure to use as the limited company route, however it does represent a ‘hassle-free’ way to contract.
If you’re on a short-term contract, or ‘testing the water’, the umbrella option is a wise one, as there are no set-up costs, nor do you have to deal with the obligations of setting up, running, and possibly closing down a limited company.
Importantly, you should only ever deal with a legitimate PAYE umbrella company, and keep clear of any ‘offshore’ tax avoidance schemes which have been aimed at the freelance market over the years.
For in-depth information, read our complete guide to umbrella companies.
Pros: relatively easy to join, fast set-up, minimal admin.
Cons: less tax-efficient than limited, umbrella industry is unregulated, limited control
Limited vs Umbrella – comparison tools
- View our umbrella/limited comparison table for a concise view of the pros and cons of using each business structure.
- To compare the tax liability you will pay as a limited or umbrella contractor, try our Net take-home pay calculator.
- See how much some of the leading umbrella companies charge in monthly fees.
If your contract work is subject to a notorious piece of tax legislation – IR35 – then the benefits of contracting via your own company are vastly reduced, and an umbrella company may be the preferred option as a result.
IR35 was introduced in 2000 after the Government sought to clamp down on the practice of ‘disguised employment’, whereby a worker might leave a traditional job on Friday, only to return as a limited company contractor the following week; enjoying the tax benefits of the incorporated structure, but working in an identical way to that of an ’employee’.
In addition, the rules were complicated further following ‘off-payroll’ changes implemented in April 2017 which forced public sector clients to be responsible for determining the IR35 status of contractors. These rules were extended to private sector contractors too from April 2021.
As a result of the Off-Payroll implementation, some end-clients implemented ‘blanket bans’ on limited company contractors – albeit as a short-term reaction to having to comply with the obligations of the new rules.
This means that you may have to use an umbrella company for certain contracts, and not for others.
You can find out more about IR35, and the financial consequences of being caught, here.
- If you want to set up a limited company, take a look at our recommended accountancy providers.
- Alternatively, try our list of umbrella company providers.
- Many of the leading accountancy firms offer so-called ‘flex’ arrangements, whereby you can operate as a limited company contractor for IR35-free contracts, and work via an umbrella company for inside-IR35 contracts. All for one monthly fee.