When you start your contracting career or at any point during it, there are three structures you can choose from to carry out business - registering as a sole trader, using services of an umbrella company, or setting up your own limited company.
Depending on which option you choose, you’ll be subject to different rates of tax and different reporting and payment schedules.
Below we focus on different types of taxes you pay depending on the structure you choose, when you have to make payment to HMRC, and how those taxes affect your cash flow.
Click here to read more on how our services benefit contractors and various accounting packages that we offer that can help you structure your work in the most tax-efficient manner.
The contracting sector in the UK
There are now an estimated 4.6 million contractors in the UK. Many people think that contractors only specialise in IT but they actually provide services to companies and organisations across a much wider spectrum of skills.
The top 25 paying contractor skillsets in the UK, according to Emolument.com, are:
- Business analysis contractors
- Change / risk management contractors
- Corporate finance & M&A strategy contractors
- Credit risk management contractors
- Data analysis contractors
- Engineering contractors
- Finance model validation contractors
- Finance risk modelling and quant contractors
- Financial change management contractors
- Interim manager contractors
- IT contractors
- IT enterprise architecture contractors
- IT security contractors
- IT senior management contractors
- IT service delivery contractors
- Locum doctors
- Oil and gas contractors
- Operational change management contractors
- Operational risk management & risk analytics contractors
- Procurement & purchasing / outsourcing contractors
- Product manager contractors
- Programme management contractors
- Project management contractors
- Seafarer
- Self employed general contractors
- Software development contractors
- Strategy consulting contractors
This is only a small part of the landscape however. Well paid contractors can also be found in marketing, sales, construction, product design, health and safety, and much more.
Taking a snapshot right now of how contractors choose the structure for their career, this is how it stands today:
- 86% choose a limited company or sole trader structure.
- 14% choose to be represented by an umbrella company.
The growth of contracting in the UK has been steady and consistent over the last two decades.
For most contractors, they make a positive decision to leave full-time employment to start their contracting career – it doesn’t happen by accident or circumstance as much as you might think. Most will start off as either as a sole trader or under a company umbrella, eventually graduating to owning their own limited company.
Later on, we’ll explain what all those distinctions mean and the various pros and cons of each type of contractor career set-up.
As the price for and consistency of work increases over a contractor's career, contractors find that they have both more time and more financial justification for working through a limited company than working via either an umbrella or as self-employed.
To explain how a limited company can become more attractive over time, it’s first important to understand the workload associated with both. Below you can see how the work-related hours of an umbrella contractor and a limited company contractor differ, with the illustration divided between time working for client, time spent on administration, and time spent on market.
In your early contracting career, it makes sense to use an umbrella company to find work and to start the process of building your own network of contacts and decision-makers who can give you work later on.
For every hour worked, after tax and deductions, you will be left with between 60-70% of your salary. With your focus needed on delivering high quality work, it’s best to get someone else to do your marketing for you and to look after your paperwork and taxes, enabling you to spend much more of your time earning and bringing value to your clients.
However, as your career develops in both contacts and fees earnt, most contractors choose to transfer their contracting activity into a limited company, which despite the paperwork has more financial benefits. With a limited company you can take home just as much or even more than umbrella contractors while working fewer hours in the week or fewer weeks in the year. That’s because, as you will see in this article, contractors operating a limited company tend to take home a much greater proportion of their billing income than an umbrella contractor.
However, the trade-off is that you need to spend more time on paperwork and you may find yourself spending even more precious time looking for contracts and pitching for the work.
Becoming a contractor using a limited company is a destination that most contractors eventually reach, although each individual will take their own time and their own route to get there. In this next part of the article, we’ll look at the pros and cons of all three structures.
The ins and outs of contracting through a limited company
A limited company is the most popular choice of business structure for contractors. It does involve more reporting and paperwork than setting up as a sole trader contractor however, in most cases, there is a significant financial benefit to doing so.
Contractor limited companies have to pay corporation tax on profits once a year and, if registered, VAT once a quarter. The owners of contractor limited companies, sometimes called personal service companies, also pay Income Tax, National Insurance, and dividend tax.
Limited company salary and dividends for contractors
Most limited company contractor directors pay themselves a mixture of salary (which you can deduct from your profits) and dividends. A dividend is a redistribution of money held by your limited company to its shareholders – i.e. you. Dividends are paid out of money after corporation tax liabilities have been taken into account. Dividend payments do not reduce the profit you declare to HMRC.
Limited company National Insurance for contractors
You will pay National Insurance Employer’s Contributions based on the level of salary you take from your contracting business. Your company will also pay National Insurance Employer’s Contributions to HMRC based on the level of wages you pay yourself.
There are ways that you can structure the payment of your salary to minimise income tax and both forms of National Insurance – read more below.
Limited company corporation tax for contractors
Corporation tax is payable once a year, nine months after your year end. It’s equivalent to 19% of your net profits. Your net profit is worked out by subtracting all of your allowable costs (including your salary) from the amount of money you turned over in a year.
Click here to find out more on how to register a company and here for how to register for corporation tax.
Limited company VAT for contractors
You must register for VAT once your turnover passes or is likely to pass £85,000 in your company tax year period. You can register for VAT with a lower turnover however it’s best to take Pulse Accounting’s advice on whether doing so would fit your own personal circumstances before you decide to do so.
When you’re VAT-registered, you must charge 20% VAT on your services to clients. Once a quarter, you send a VAT return back to HMRC – you work this out by adding together all of the VAT on invoices you’ve issued then subtracting the VAT on all the invoices you’ve paid. You pay VAT on the 7th of the second month following the end of your VAT quarter. Different VAT schemes are available so it’s well worth speaking to your Pulse Accounting team member to find out which system would be best for you.
It sounds quite complicated but, by using FreeAgent, our online bookkeeping software, this can work your VAT out for you. Register for VAT by clicking here.
The ins and outs of contracting as a sole trader
A limited company is a separate legal entity from its shareholders and directors – it has its own money, it can sign up to its own agreements, and more. Opposed to this, if you choose to launch your contracting career as a sole trader, you are your business and your business is you. Whilst that does mean there’s less paperwork, there is a price to pay for it in the amount of tax you pay to HMRC.
Sole trader income tax for contractors
When a limited company makes profit, it pays tax on that profit. The limited company’s director will then decide to pay its shareholders in salary and dividends who pay their own personal taxes. As a sole trader, there is no such separation between company profit and income. You pay income tax on the entirety of the profit/income you make.
Sole trader National Insurance for contractorsYou’ll pay two versions of National Insurance on your profit/income during the year as a sole trader – Class 2 and Class 4. If you earn more than £6,205 a year, you’ll pay £2.95 a week in Class 2 contributions, 9% in Class 4 contributions on profits between £8,424 and £46,350, and 2% in Class 4 contributions on profits about £46,350.
Sole trader payments to HMRC for contractors
The sole trader contractor tax year runs from 6th April to the 5th April. So, for any work carried out between 6th April 2018 and 5th April 2019, you must fill in a Self Assessment form and submit it by 31st January 2020 and you must make payment for it at the same time.
There is a sting in the tail though. A sole trader contractor must make a payment on account by 31st July every year. Let’s say that, on the Self Assessment you had filled in and submitted by 31st January 2020, you owed £20,000. On the 31st July, you then have to make a payment on account of half of that amount meaning that you’ll pay over £30,000 in taxes between 31st January and 31st July 2020. This arrangement with HMRC has and continues to put severe strains on sole trader contractor cashflow in your second year of trading.
The ins and outs of contracting through an umbrella company
Finally, there are umbrella contractors. Contractors using this working arrangement become employees of an umbrella company. At the end of each week, you ask your client to sign a timesheet displaying the days and hours you worked. You send the timesheet to your umbrella company including a full itemisation of the expenses you incurred (please note that subsistence and travel expenses can no longer be claimed).
When you send your timesheet over to the umbrella company, they then invoice the client at the rates agreed and for the expenses incurred. When the client pays your umbrella company, they then release this payment to you minus tax, National Insurance, and the umbrella firm’s fees. This simplifies the tax elements of being a contractor considerably.
Umbrella company income tax
Umbrella contractors pay income tax at the same rates as employees and a sole trader contractor on their income after umbrella fees and expenses deductions. Similarly, you have a personal allowance each year of £11,850 before income tax is payable. This is deducted every month by your umbrella company and paid to HMRC on your behalf on or before the 22nd of the following month.
Umbrella company National Insurance
You pay National Insurance at the same rates as the standard employees working at your client’s firm do. Both forms of National Insurance are held by your umbrella until the 22nd or before of the following month before they’re transferred to HMRC.
Umbrella company benefits
Umbrella firms normally work with employment agencies to find their contractors work. In addition, as an employee, you are entitled to workplace pensions, holiday pay, sick pay, parental leave, and so on. Out of all three options, the umbrella route offers contractors most of the securities offered by being directly employed by a client.
Tax Pros and Cons of Different Contractor Career Structures
What tax do you pay and when?
|
Limited company |
Sole trader |
Umbrella contractor |
|||
|
Corporation tax |
9 months after year end at 19% |
VAT |
Once a quarter, if registered |
Income tax |
Every month you are paid by your umbrella |
|
VAT |
Once a quarter, if registered |
Income tax & Class 2/4 NI (year 1) |
31st January (one payment only) |
National Insurance |
Every month you are paid by your umbrella |
|
Income tax, National Insurance, and dividend tax |
31st January (one payment only) |
Income tax & Class 2/4 NI (year 2) |
31st January reporting with two payments on account – 31st January and 31st July. |
VAT |
Umbrella contractors are never VAT registered although their umbrellas mostly are |
For sole traders, do not forget that you have to make a “payment on account” on 31st July. As mentioned earlier, this “payment on account” is calculated using your last reported Self Assessment and it’s a down payment of 50% on your following year’s expected tax liability.
Payments on account are not something that contractors using limited companies or umbrella contractors have to make.
Umbrella v Ltd Co v Sole Trader – The Big Contractor Choice
Contractor limited company vs sole trader contractor vs umbrella – worked example
The average contractor wage in the UK is £57,500. Depending on whether you choose to be a sole trader or limited company contractor, this is how your income would be taxed for the 2018/2019 tax year assuming that:
- the company year for the limited company contractor ends on 31st March 2019 and
- this is your first year in business as a limited company contractor
|
Limited company |
Sole trader |
Umbrella contractor |
|||
|
|
Amount |
|
Amount |
|
|
|
Annual profit before salary |
£57,500 |
Profit/income |
£57,500 |
Profit/income |
£57,500 |
|
Salary |
£11,850 |
Minus personal allowance |
£11,500 |
Subsistence costs |
£3,300 |
|
Employers NI |
£472.79 |
Taxable income |
£45,650 |
Umbrella admin |
£1,434 |
|
Annual net profit |
£45,177.21 |
Income tax |
£11,360 |
Employers NI |
£5,407 |
|
Tax on profit |
£8,583.67 |
National Insurance Class 2 |
£153.40 |
Taxable pay after personal allowance |
£35,758 |
|
Dividend paid to yourself |
£36,593.54 |
National Insurance Class 4 |
£3,636.24 |
Income tax |
£7,403 |
|
Tax on dividends |
£3,117.90 |
|
|
Employee’s NI |
£4,579 |
|
Total take home pay |
£44,914.52 |
Total take home pay |
£42,350.26 |
Total take home pay |
£35,625 |
As you can see, there is a significant saving to be made by setting up your contracting business as a limited company as opposed to as a sole trader or as an umbrella. In addition, the fact that you don’t have a payment on account as a limited company contractor significantly benefits your cash flow as you can see from this HRMC payment schedule based on the above figures.
|
Work done in 2018-2019 Limited company |
Work done in 2018-2019 Sole trader |
Work done in 2018-2019 Umbrella |
|||
|
|
Amount |
|
Amount |
|
Amount |
|
Employers NI paid during 2018-2019 tax year |
£472.79 |
Payment due to HMRC (Self Assessment on 31st January 2020) |
£14,996.35 |
Deductions made by umbrella for taxes and fees |
£1,843 a month (paid following month) |
|
Corporation tax due on 31st January 2020 |
£8,583.67 |
Payment on account (due 31st July 2020) |
£7,498.17 |
Corporation tax |
N/A |
|
Dividend tax |
£3,117.90 |
Total paid to HMRC in 2020 from FY18-19 |
£22,494.52 |
VAT |
N/A |
|
Total paid to HMRC by you and your Ltd Co in 2020 from FY18-19 |
£12,174.36 |
|
|
Total paid in fees and taxes |
£22,116 |
A limited company contractor will, for cash flow purposes, pay at least £10,320.16 less in tax personally and through his or her company than his or her sole trader colleague or umbrella colleague.
IR35, the contractor tax
All of the examples given above assume that you, as a contractor, are working outside the scope of IR35. IR35 is, and has been for the last near-twenty years, one of the defining features of life in the UK as a contractor.
IR35, originally introduced in 2000 and sometimes called the “Intermediary Regulations”, was designed to arrest the fall in tax revenues to HMRC when a member of staff leaves work as an employee only to return as a self-employed contractor very shortly afterwards.
How does the tax you pay change when you move from being outside IR35 to being inside?
Let’s look at the difference to a contractor earning £65,750 setting aside no money for pension contributions and spending £50 per week on travel using a limited company and outside the scope of IR35 versus the same contractor caught by IR35’s rules.
|
Outside IR35 |
Inside IR35 |
||
|
|
Amount |
|
Amount |
|
Earnings |
£65,750 |
Earnings |
£65,750 |
|
Income tax, National Insurance Employee Contributions, and dividend tax |
£5,700.83 |
Income tax and National Insurance |
£15,683.56 |
|
Corporation tax |
£10,151.17 |
Corporation tax |
£627.00 |
|
Employers’ NIC |
£472.79 |
Employers’ NIC |
£6,551.48 |
|
Earnings after tax |
£49,425.21 |
Earnings after tax |
£42,887.96 |
|
Additional tax under IR35 |
£6,537.25 |
||
As you can see, the person working within IR35 rules will pay £6,537.25 more.
If HMRC think that your agreement with a client falls within the scope of IR35, they will attempt to establish a “hypothetical employment contract”. This is a method of characterisingthe terms of your engagement with your client as being more like that of“employer-employee”, something HMRC calls “disguised employment”.
This is a complicated area in which Pulse Accounting has a lot of experience to offer our contractor customers – to read more, please click here (this is where the link would go to the IR35 article recently written).
