There are two ways to maximise your take-home pay as a contractor – by negotiating the best contract rate, and by not paying more tax than you have to.
Depending on whether you are an umbrella or limited company contractor, there are a number of taxes you will encounter.
1. Limited Company Tax
Limited companies are separate legal entities from their directors, so your company will pay taxes on its profits, and you (as an individual) will be liable to pay tax on any income you receive from your company.
All companies pay Corporation Tax (CT) on their annual profits. The current rate is 19% (2020/21 and 2019/20 tax years). Your accountant will register your company for CT after your company is incorporated, and will prepare your Annual Accounts each year, and submit them to Companies House (the registrar of companies in the UK), and HMRC. You must pay your Corporation Tax within 9 months of your company year-end.
Find out more in our Corporation Tax guide.
Value Added Tax
The vast majority of contractor companies are also registered for Value Added Tax (VAT). VAT is applied to all services you provide to your contracting clients, and you can reclaim VAT on purchases you make via your company (subject to the conditions of any special VAT scheme you join). The standard rate for VAT (which you charge to your client) is 20%.
You will need to submit an online VAT return to HMRC each quarter, together with an electronic payment. If you elect to pay via direct debit, you have at least an extra 7 days to pay your VAT, and also a handy safeguard against forgetting to make the payment manually.
You must register for VAT if your annual turnover is £85,000 or more (2020/21, 2019/20 tax years), however, most accountants will advise you to register regardless, and you could actually benefit financially by joining the Flat Rate VAT scheme, which provides a discount for new companies during their first year in business.
Find out more in our dedicated guide to VAT.
Companies are also liable to pay Employers’ National Insurance Contributions (NICs) on all salaries paid to their staff.
As an individual, you are liable for Employees’ NICs on the salary you draw down from your company.
Most contractors pay themselves a low salary, sometimes below the NIC threshold, to minimise their exposure to both income tax and NICs.
Your accountant will be able to guide you when setting your annual salary.
Read our dedicated guide to National Insurance.
As a company shareholder, you will also pay tax on the dividends your company declares. Unlike salaried income, dividend income is not subject to NICs, providing limited company owners with a significant tax benefit.
Pre-April 6th 2016, your company would pay you a ‘net’ dividend, which is then multiplied by 10/9 to provide the ‘gross’ dividend amount upon which your tax liability is calculated.
From April 6th 2016, the old system was overhauled, and now a system of flat dividend tax rates exists.
Read more about dividends and how they are taxed.
Income Tax / Self Assessment
Individual limited company contractors settle their income tax liabilities via the annual self-assessment process. You must submit your tax return by 31st January each year together with payment. You may also have to make two payments on account (31st Jan and 31st July) towards the current year’s tax liability. The payment on account amounts assume that you will earn the same income this year as you did in the previous tax year.
Read more in our guide to the Self-Assessment process.
2. Umbrella Company Tax
As an umbrella company employee, you are taxed in the same way as you were as a traditional employee with your last employer. Your entire income, after making allowances for the umbrella company fee, and any other deductions (pension contributions, for example), is subject to standard Paye As You Earn (PAYE) calculations, and you will pay National Insurance on your income.
Your umbrella provider will process your payroll on your behalf, and any deductions will be shown on the payslip.
Unless you have earned other income during each tax year (such as investment income, or income from letting out a property), you do not need to register for Self Assessment.
Check with your account manager, or an accountant, if you’re unsure whether any additional income should be declared via the self-assessment process.
3. Other Issues
Introduced in 2000, the Intermediaries Legislation (a.k.a ‘IR35’) could have a significant effect on your income as a limited company contractor if your contract work is deemed to be one of ‘disguised employment’. If you are caught by IR35, then all your income will be paid in the form of a ‘deemed salary’ (subject to PAYE), after allowing for a 5% allowance to reimburse you for the costs of running a company.
Clearly, you should take steps to ensure that your assignments fall outside the scope of IR35, otherwise, you will be significantly worse off as a result.
Umbrella company contractors are not affected by the IR35 rules, as they are already taxed as employees.