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UK Contractors; Limited Company v Umbrella?

What are the benefits for contractors of setting up a Limited Company vs Umbrella Company? Read our guide, see how much you could take home in each setup.

The contractor's choice: Limited company vs Umbrella

As a skilled individual you may not want to be tied to one employer under a permanent employment contract. Instead, you could take short-term contracts which are routed either through your own limited company, or through an agency organisation referred to as an Umbrella company (because it covers a number of contractors).

Most large organisations will not take on contractors as self-employed individuals without the wrapper of a limited company or Umbrella company round the worker. Those wrappers protect the hiring organisation (your client) from having to extend employment rights to you, and prevent you from being counted as part of the organisation’s payroll headcount.

Limited company offers some tax savings

Contractors who work through their own limited company can save tax and national insurance contributions (NIC), compared to working under an Umbrella company. However, the amount of tax and NIC saved depends on the level of income the company receives, and how the profits are paid out to the contractor. Using a limited company will allow the contractor to register for VAT and take advantage of the flat rate VAT scheme.

The Flat Rate What Now? The flat rate VAT scheme is a simple way to calculate VAT due to HMRC, and it provides a cash advantage to most contractors. The company can apply to use the flat rate scheme if its annual income is not expected to exceed £150,000.

The company can pay you, the contractor, a salary and certain tax-free expenses, including a contribution to a registered pension scheme held in your name. It must then pay its own corporation tax liabilities, plus VAT and NIC on your salary (within limits). Any funds that remain represent profit which can be paid out as a dividend, or left within the limited company until such time that you want to extract it or close down the company.

You chose how much to take as a salary, and therefore how much money will be left to pay out as a dividend. The mixture of salary and dividend affects how much tax you will pay, as dividends are currently taxed at lower rates than salary (see below). However, if you receive a salary of over £8060 per year you also have to pay employee’s class 1 NIC. The tax rates due on the three bands of income are:

Taxable income – after deduction of personal allowance Salary taxed at Employee’s class 1 NIC Dividends taxed at
Basic – up to £32,000 20% 12% 7.5%
Higher – 32,001 to 150,000 40% 2% 32.5%
Additional over £150,000 45% 2% 38.1%
  1. Notes
  2. Employee’s NIC at 12% applies in the band £8060 to £43,000, and at 2% on earnings above £43,000
  3. The first £5000 of dividend income is taxed at 0%, and no NIC is due on dividend income.
  4. The thresholds for the tax bands can be increased by making contributions to a registered pension scheme or donations under gift aid.

Number crunching

It’s complicated, but we have set out two examples below to compare the tax benefits of a limited company and an Umbrella company at two levels of income. As you can see, the financial gain from operating under a limited company structure is slightly more than the umbrella structure at £30,000. The tax advantages of the limited company are greater at the £60,000 level of annual income.

Annual Income £30,000
  Limited Umbrella
Annual Income £30,000 £30,000
Add Flat Rate VAT Saving £780 £0
Turnover £30,780 £30,000
Expenses £2,400  
Accountancy Fees £1,080 £960
Salary £8,060 £26,499
Employers NIC £0 £2537
Pre-Tax Profit £19,240 £0
Corporation Tax £3,848 £0
Profit After Tax £15,392 £0
Personal Income Details
Gross Salary £8,060 £26,499
Less - PAYE on Salary £0 £3,099
Less - NIC on Salary £0 £2,213
Net Dividends £15,392 £0
Less - Tax on Dividends £559 £0
Expenses £2,400 £0
Total Income After All Taxes £25,293 £21,187
Take Home Pay % 76% 71%
Annual Income £60,000
  Limited Umbrella
Annual Income £60,000 £60,000
Add Flat Rate VAT Saving £1,560 £0
Turnover £61,560 £60,000
Expenses £2400 £0
Accountancy Fees £1,080 £960
Salary £8060 £52,860
Employers NIC £0 £6,175
Pre-Tax Profit £50,020 £0
Corporation Tax £10,004 £0
Profit After Tax £40,016 £0
Personal Income Details
Gross Salary £8,060 £52,860
Less - PAYE on Salary £0 £10,344
Less - NIC on Salary £0 £4,229
Net Dividends £40,016 £0
Less - Tax on Dividends £3,675 £0
Expenses £2,400 £0
Total Income After All Taxes £46,801 £38,287
Take Home Pay % 73% 64%

Disadvantages of limited company

If you run your own limited company you will own the shares and be the company’s director. As such you will have full responsibility for the company’s financial accounts, tax and VAT returns, and for making returns to Companies House as required under company law.

You will also be responsible for reporting your own income on your personal tax return under self-assessment. All these responsibilities can eat into your home and family time, and there are heavy penalties to pay if tax returns are not filed when due, and the tax is not paid on time. The company, PAYE and VAT returns must be submitted online.

If your contract is within IR35, you will not be able to use all the of tax advantages offered by operating through your own limited company, but you will still have the legal responsibilities of running the company and submitting its tax returns.

Umbrella contract is less hassle

If you chose to take a contract through an Umbrella company, you will be an employee of that company. The Umbrella administrators will invoice your client, receive the fees due and then pay you a salary. Tax will be deducted at source from that salary under PAYE, but the Umbrella will also deduct the employers’ NIC from the gross income it receives. As a result you will receive less than if you were a permanent employee of your client, on the same money.

You will also receive less take-home pay than you would by working through your own limited company.

You will not a be a company director of the Umbrella company, and you will have no responsibility for the financial accounts or tax payments made by the Umbrella company. However, you will be responsible for your own tax affairs including submitting a self-assessment tax return, if HMRC ask you to complete one.

Disadvantages of an umbrella company contract

  • You have no control over the company or the company accounts or policies. You are not a director of the Umbrella company.
  • It may take longer to receive payment as monies have to transfer through the Umbrella company’s account before arriving in your personal account. How long that takes is down to the discretion of the Umbrella company.
  • You take on a certain amount of risk as your money travels through the bank account of a company you have no control over. Should the Umbrella company fail or the directors of that company be prosecuted for any reason, you may lose the pay due to you.
  • Agency worker regulations mean that if your contract lasts for 12 weeks or more you must be granted the same employment rights as permanent members of staff. This includes being paid holiday pay, sick pay, and pension contributions. The Umbrella company administrator may withhold a proportion of your salary to cover those costs.
  • If your contact is outside IR35, choosing an Umbrella company will mean you pay more in tax than you would by operating the contract through your own limited company.
  • If your contract falls inside IR35, choosing an Umbrella contract will leave you slightly worse off financially.

Differences between a limited company and an Umbrella company

Limited company

You, as the company owner, have full responsibility for the financial accounts, tax and VAT returns, company law obligations, etc. You must declare your own personal income and pay tax through self-assessment. Missing deadlines for submitting tax returns or paying tax will mean you incur automatic penalties. You also risk being penalised for making mistakes in tax returns.

The risk of penalties can be greatly lessened by using experienced contractor accountants.

Umbrella company

You are not a company director and have no responsibility for the financial accounts and tax returns of the Umbrella company. You will be an employee of the Umbrella company, who will collect your money on your behalf from your client and pay you a salary after deducting their fees and tax due under PAYE. However, more tax will be paid overall, resulting in a lower take-home wage.

Your legal responsibilities are limited to your own tax affairs, and the risk of incurring penalties for late filing or late payment are minimal.

Advantages of a limited company structure

  • You have complete control over your money and your company.
  • Your money doesn't have to pass into a third party bank account, which means a faster transaction time and no risk to these earnings.
  • Where the contract is deemed outside of IR35, there is less tax and NIC to pay.

Advantages of an umbrella company structure

  • Avoids the burden and risk of being responsible for the accounts and returns of the company.
  • Salary is paid to you as if you were an employee.
  • You don’t have to incur the costs of setting up a limited company, this is especially advantageous if you will be contracting for short period.

Next step

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.

This guide was sponsored by Churchill Knight & Associates Ltd. an established accountancy practice, specialising in Contractors & Freelancers. They offer a free guide to contracting you can download here.