Contractor set up Guide: Limited Company v Umbrella
Independent contractors will face an initial choice on which business structure best suits their working needs. Many factors need to be considered when deciding which to use. This guide aims to highlight the advantages/disadvantages of both
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|
|Umbrella Setup Advantages||Umbrella Setup Disadvantages|
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.
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.