After deciding to make the move into the world of IT contracting, the first task for any aspiring contractor is to decide upon the best business structure to work under.
Clients hire 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.
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 article, we look at the two key business structures used by contractors – the limited company and umbrella company.
If you set up your own limited company, you will 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 in the form of 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, who can also undertake a number of other initial tasks, such as setting up the company payroll and registering the company for Corporation Tax and VAT.
The number of umbrella company schemes operating in the UK has grown rapidly over the past decade.
If you join a PAYE umbrella company, you will become an ’employee’ of the scheme. The client pays the scheme when you have submitted a weekly or monthly invoice, and you will receive a salary after deductions for tax, National Insurance, expenses, the umbrella fee, and any other pre-agreed costs.
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, which may appeal to contractors who are testing the water, short-term contractors, and those who do not want to take on any form of administration.
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.
Comparison Table / Calculator
- 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 owe 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 will be extended to private sector contractors too from April 2021 (after a one year delay announced in Budget 2020).
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.
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- Switch between umbrella and limited - flexible solution from Nixon Williams for contractors affected by the Off-Payroll changes.