If you have taken a step towards IT contracting, you will find yourself faced with determining which business structure will work best for you.
It’s common for clients to hire contractors based on a business-to-business basis. This means that there are several ways in which contracts are put in place.
The first is a Direct contract, which is put in place between the contractor’s limited company or umbrella company and the client. The second is through agencies whereby the contract is put in place between the client company and the recruitment agency. In contrast, another will be between the recruitment agency and the contractors’ own limited company or umbrella company.
This article will consider the two main business structures that contractors use. Limited company and an Umbrella Company.
When you set up a limited company of your own, you will be considered the company director. With this comes a variety of statutory and financial obligations that you have to follow. Along with this, you will be expected to submit accounts to Companies House on an annual basis. Ensuring you take responsibility for meeting all HMRC tax deadlines and running the company solvently.
While there is a lot of work involved in running a limited company, it is possible to have the work completed by a specialist accountant. However, you will still be responsible for ensuring you meet all obligations. The majority of contractors will work through their own companies. There is a wide range of contractor accountants who will be willing to show you how it all works.
If you contract through a limited company, then one of the main benefits you can take advantage of is that it is one of the most tax-efficient solutions out there when it comes to running a business. In contrast to being a permanent or umbrella employee, you will pay yourself a salary, which is relatively low, before making up the remainder with dividends. These dividends are not susceptible to National Insurance Contributions, which can help you save on tax. However, the amount you could benefit from was dropped significantly in April 2016 after dividend tax rates were given a complete overhaul.
You will also have flexibility when it comes to taking an income from the company. With that comes even more tax planning benefits. This is because you will have the ability to transfer a portion of the shares to your spouse.
Limited companies have a requirement to pay Corporation Tax, which comes in at 19% on all annual profits. In contrast, VAT has to be included on all invoices, which then has to be paid to HMRC during each quarter, following any VAT that can be reclaimed on any company purchases that you have made.
To begin the process, you will need to create a new company. This process is not expensive and takes very little time. For less than £12, you can directly incorporate with Companies House. Although contractors commonly choose to leave this process with their accountant. Along with this, they will also carry out all other tasks. This includes setting up company payroll and registering the company for VAT and Corporation Tax.
Over the past ten years, there has been significant growth in the number of umbrella company schemes that are in place in the UK.
When you choose to join a PAYE umbrella company, you will be considered an employee of the scheme. This means that the client will submit payment to the scheme once you have submitted your invoices. Following this, you will be paid a salary with all Tax, National Insurance, expenses, and the fee deducted from it.
Compared to a limited company, it is not as tax efficient. This is something that people need to consider when looking at a limited company vs umbrella company. Despite this, what it does offer is that it makes it easier to operate as a contractor. Especially those who are new, are undertaking short term contracts, and those who want to reduce the amount of administration they handle.
What is important to remember is that you only ever work with a legitimate PAYE umbrella company. This means avoiding any offshore schemes that encourage tax avoidance, something which has been marketed to freelancers through the years.
There is a significant reduction in benefits by operating through your own company if the contract work you undertake is governed by the tax legislation, IR35. This might mean that operating via an umbrella company is likely to be the best option.
In 2000, the government introduced IR35 to attempt to prevent the practice of disguised employment. This would involve a worker leaving their traditional job at the end of a working week. Then coming back on the Monday as a limited company contractor. Giving them access to the benefits that come with an incorporated structure even though they would operate in the same way an employee.
Along with this, the rules we also made more complicated after additional changes were brought in for off-payroll in April 2017. This meant that public sector clients would be held responsible for identifying the IR35 status of contractors. As a result, the rules were then put in place for private sectors, which will come into effect in April 2021, ensuring that everyone has to remain within the confines of the law.