The PAYE (Pay-As-You-Earn) system collects income tax and National Insurance liabilities from employees’ earnings. Here we look at how PAYE works for contractors, and how to set up your company payroll.
If you’re an umbrella company contractor, or a limited company director who receives a salary, any taxes you owe on your salary will be collected via PAYE.
How the PAYE system works
All employers are responsible for calculating, and collecting taxes owed on their employees’ earnings.
Every time wages are paid to employees, details of each payment are sent by the employer to HMRC. Any taxes owed by the employees are kept aside by the employer, and then subsequently paid to HMRC before the relevant deadline.
So, how does the PAYE system affect contractors?
Umbrella company contractors receive payslips for each period they work (typically weekly or monthly), and need take no further action, as umbrella schemes take care of the entire payroll administration.
If you’re operating your own company, your accountant will run a monthly payroll on your behalf, and provide you with a payslip.
Your company is then responsible for paying any taxes you own on your salary to HMRC – typically on a quarterly basis.
At the end of each tax year (which runs from 6th April – 5th April), each employee must be given a P60 which details their total earnings (salary) over the previous tax year, minus any deductions.
Rather than providing payroll data to HMRC at the end of each financial year, payroll information is now submitted in ‘real-time’, when a payroll is run. This is due to the implementation of the ‘Real Time Information’ regime, which was phased in from October 2011 onwards.
Limited company payroll
If you’re going to trade via your own company, you will need to set up your own payroll. Unless you’re thinking of looking after your own accounts (and this isn’t advised unless you have the right experience), your accountant will do this for you.
Here are the basic steps to follow when setting up your company payroll:
- Your company needs to register as an employer with HMRC.
- You need to register each employee on the payroll with HMRC (use the information on their P45 initially).
- Every time you run the payroll, your accounting software will transfer the information to HMRC (in ‘real-time’).
- You must pay any taxes your employees owe to HMRC within the agreed time period. See below for deadlines.
Any deductions made on behalf of employees must be paid to HMRC monthly if the combined income tax and NIC liability of all your employees averages £1,500 or more. If it is less (as it usually is for limited company contractors), you can pay quarterly.
Payments must be made to HMRC within 14 days of the end of the tax month, which falls on the 5th of each month. So, by the 19th of each month, or the 22nd if you’re making an electronic payment.
Umbrella schemes take care of all payroll administration on behalf of their clients. If you’re a company director, your accountant (or your accounting software) should inform you when you should make a payment, and how much is due.
Each employee has a tax code, which tells the employer how much tax should be deducted from their earnings.
The most common code for the 2022/23 tax year is 1257L, where the initial digits multiplied by 10 indicate how much personal allowance the individual is entitled to.
Read our comprehensive guide to tax codes, and how they affect your take-home pay.
Benefits in Kind
If your company pays for anything which you benefit from personally (e.g. use of a company car), you must pay tax on the value of this benefit.
All such benefits are included on each employee’s annual P11D form, which must be filed by the company by July 6th following the end of each tax year. Any Class 1A NICs payable on the value of these benefits must be paid by 19th July.
Your tax code (see above) may be adjusted for the following year to account for these benefits in kind, on the presumption that you will receive the same benefits in the following tax year.
You can download a sample P11D form here.
Importantly, the PAYE system only deducts tax from wages (i.e. income paid via the payroll system). If you receive further income on top of your salary, you will have to account for this via the self-assessment system.
If you’re a limited company director, you must fill in an annual tax return each year, and if you’re an umbrella employee who has received untaxed earnings, you must also complete a return.
Most limited company contractors receive small salaries (taxed via the PAYE system) and draw down the bulk of their income in the form of dividends. Any tax due on dividend income needs to be paid via self-assessment.
The deadline for submitting a tax return, and paying any tax you owe, is the 31st January following the end of the tax year to which the return relates, i.e. 31st January 2020 for the tax year ending 5th April 2019.
Find out how to complete your SATR in our guide to self-assessment.
You can read comprehensive official guides to PAYE, payrolls, and registering as an employer via GOV.UK.