Contractor set up Guide: Limited Company v Umbrella

Contractor set up Guide: Limited Company v Umbrella

Sept 2015: This guide has been updated. Please see the latest guide here on our Limited vs Umberella guide

Independent contractors will face an initial choice on which business structure best suits their working needs. Many factors need to be considered when deciding whether to trade as a limited or via an umbrella company. This guide aims to highlight the advantages and disadvantages of each, thus enabling you to make an educated decision as to which best suits your particular situation. 

One of the first factors to establish is your status with regards to IR35. As an umbrella worker, IR35 does not apply to you. Operating via a limited company is particularly beneficial where the company is seen by HMRC to operate outside of IR35, i.e. where the Inland Revenue does not consider you a disguised employee for tax purposes. We’re not going into the whole “are you IR35 or not” here, but we would recommend speaking with experienced contractor accountants if you need advice on this matter.

In most instances, if your annual earnings are under £30,000, or your contracting career is expected to be short term (less than 9 months), an umbrella company set up is the easiest and most cost effective option.

Limited companies can offer significant tax savings…

Company profits are liable to corporation tax of 20%, after which the profits may be paid out as dividends. Dividends are taxed, but because corporation tax has already been paid on these profits, the rate at which they are taxed is discounted.

Contractors who work through their own limited company can make significant tax and NIC savings by paying themselves a low salary, then taking the majority of their earnings as dividends from their company's profits. Contractors pay less tax on dividends because dividends are not subject to National Insurance Contributions (NIC's), unlike an umbrella company set up where all earnings are subject to both Employee and Employer NIC's.

Another significant advantage with a limited company structure is that a contractor can avail of the Flate Rate VAT Scheme. This allows a business to keep 1% of the amount charged as VAT for the first year of business. (for companies with an estimated turnover of less than £150k).  For example, an IT contractor will invoice for services provided at 14.5%, but will only repay 13.5% of the amount invoiced to HMRC.

Differences between a limited company and an umbrella company

  • In a limited company the contractor, being the owner and a director, has full responsibility for the financial accounts, tax and VAT returns, company law obligations, etc. The contractor declares their own personal tax through self-assessment. This means a lot more paperwork and time spent on accounts. This workload can be greatly lessened by using experienced contractor accountants.
  • In an umbrella company, the contractor is not a company director and has no responsibility for the financial accounts, tax, etc. The contractor will be an employee of the umbrella company, who invoice the client, receive the fees and then pays it to the contractor as a salary, obviously after deducting their own Umbrella fees. This keeps your paperwork to a minimum. Tax on the salary is deducted at source (like a normal employee), however more tax will be paid overall, resulting in a lower take home wage.
Pros and Cons of Both Structures
Limited Company Advantages Limited Company Disadvantages
  • The contractor has complete control over his money and company
  • Money does not have to pass into a third party bank account, so faster transaction times and no risk to these earnings
  • For those deemed outside of IR35, significantly more flexibility to pay less tax and NIC's
  • Financial benefits exist even if deemed within IR35 when compared to an umbrella setup
  • A wider range of legitimate expenses can be claimed, including accountancy fees, equipment and software costs
  • Contractors can avail of the Flat Rate Vat Scheme.
  • The amount of paperwork involved in invoicing, tax returns, etc, but remember this can be lessened by using the services of a specialist accountancy firm.
  • If you are within IR35, you will not be able to avail of all the tax advantages of setting up a limited company, but will have the additional overhead of taking care of the company accounts.
Umbrella Setup Advantages Umbrella Setup Disadvantages
  • Avoids the time and trouble of having to look after the accounts and returns of the company.
  • Net salary is paid to you as if you were an employee.
  • Not having to incur the costs of setting up a limited company; this is especially advantageous for those who know they are only contracting for a short term.
  • The contractor has no control over the company or the company accounts or policies. They are not a director.
  • It will take longer to receive payments as monies have to transfer through the umbrella company’s account before getting to the personal account of the contractor. How long that takes is down to the discretion of the umbrella company.
  • The contractor is leaving himself open to a certain amount of risk as his money will be paid to the bank account of a company he has no control over. Should that umbrella company get into trouble, which does happen, he will most likely lose his wages.
  • Agency worker regulations (AWR) mean that those of you engaged in contracts of 12 weeks or more must be afforded the same rights as permanent members of staff, including paid holiday, sick, paternity/maternity pay. Your umbrella company administrator will simply withhold a proportion of your salary to cover these.
  • For contractors working outside IR35, choosing an umbrella company will leave them paying a lot more in tax, and even if inside IR35, choosing an umbrella will leave contractors slightly worse off financially.
  • Contractor's will pay both employee NI (12% for the first £770 a week, and 1% thereafter) and employers NII (13.8% of salary) contributions.
  • Less flexibility to claim back legitimate business costs as expenses.

The Numbers

Below is a breakdown of two example incomes, £30,000 and £60,000. As you can see, the financial gain from operating under a limited company structure is significant when compared to the umbrella structure.

Example Contract: £30,000
Income Limited Umbrella
Contract earnings 30,000 30,000
Income from VAT Flat Rate Scheme 1,140  
Total Income 31,140 30,000
Salary 7,696 25,714
Employers NI   2,486
Accountancy Fees 1,325 1,800
Home Office 208  
Total Expenses 9,229 30,000
Net Profit 21,911  
Dividend 17,529  
Corporation Tax 4,382  -
Total Tax 4,382 14% 7,895 26%
Net take home 25,225 84% 20,305 68%
Example Contract: £60,000
Income Limited Umbrella
Contract earnings 60,000 60,000
Income from VAT Flat Rate Scheme 2,280  
Total Income 62,280 60,000
Salary 7,696 52,076
Employers NI   6,124
Accountancy Fees 1,325 1,800
Home Office 208  
Total Expenses  9,229  60,000
Net Profit 53,051  
Dividend 42,441  
Corporation Tax 10,610  
Total Tax 13,058 21% 21,031 35%
Net take home 47,689 79% 37,169 62%

We would strongly recommend seeking professional advice to help you decide whether a limited or umbrella company is better for your freelancing and contracting needs. Making the right decision now could help you make significant savings and stay on the right side of the taxman.