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UK Contractors; Limited Company vs Umbrella? 2018/19 tax year update

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.

Matt Poyser from inniAccountsBy Matt Poyser, who now writes for Listentotaxman.com on matters relating to contracting and limited company taxes.

Matt is a previous contractor with a wealth of experience and the Director of Client Experience at inniAccounts (an accountancy service tailored for contractors, consultants and freelancers).

Have a question? inniAccounts are happy to help Listentotaxman visitors with any queries,
simply contact them here.

Thinking of taking the leap from permanent employment to contracting independently? The first major decision you'll need to make is about your business structure. As a contractor, you can operate either through your own limited company, or as part of an Umbrella company. Both options offer their own advantages and drawbacks, depending on your personal circumstances.

To help you get started, we've created this handy guide to outline the key differences between the two structures.

The Contractor's Choice; Limited Company vs Umbrella

As a skilled individual, instead of working under one employer with a permanent contract, you might prefer to take short-term contracts from a variety of clients. These contracts can be routed through either your own limited company or through an agency organisation called an Umbrella company which covers a number of contractors.

Most large organisations won’t take on contractors as self-employed individuals without the wrapper of a limited or Umbrella company around the worker. These wrappers protect 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 Companies

With a limited company, you are the director of your own private business. You have complete control over how you work and who you choose to work with. Most contractors work through their own limited company as this structure offers autonomy, limits individual liability and provides key tax benefits.

How you'll get paid

Limited companies are the most tax-efficient way to operate. Contractors who work through their own company can save on tax and national insurance contributions (NIC), compared to working as a permanent or Umbrella employee. 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 you; the contractor.

The company can pay you a basic salary and certain tax-free expenses, including a contribution to a registered pension scheme held in your name. Limited companies must pay their 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 you want to extract it or close down the company. The flexibility over when to take income out of the company offers further tax planning benefits.

You can choose how much to take as a salary, and therefore how much money will be left to pay out in the form of dividends. The mixture of salary and dividend affects how much tax you will pay, as dividends are currently taxed at lower rates than salaries (see below). However, if you receive a salary of over £8424 per year you also have to pay employee’s and employers class 1 NIC. The tax rates due on the three bands of income are:

Taxable income – after deduction of personal allowanceEmployee’s class 1 NICSalary taxed atDividends taxed at
Basic – up to £46,350 20% 12% 7.5%
Higher – £46,351 to £150,000 40% 2% 32.5%
Additional over £150,000 45% 2% 38.1%
Notes
  1. Employee’s NIC at 12% applies in the band £8,424 to £46,356, and at 2% on earnings above £46,356
  2. The first £2,000 of dividend income is taxed at 0%, and no NIC is due on dividend income.
  3. The thresholds for the tax bands can be increased by making personal contributions to a registered pension scheme or donations under gift aid.

Advantages

  • A limited company offers the most tax-efficient solution in terms of retaining as much of your earnings as possible
  • You keep complete control of all your company's matters including your financial affairs, allowing for greater opportunities for tax planning; including drawing dividends, claiming expenses and making pension contributions
  • You have full ownership of your revenue, your client pays directly into the company bank account, rather than passing via an Umbrella company – this means faster transaction times and no risks to your earnings
  • Greater flexibility and independence, you retain control over which contracts you secure and can work as much or as little as you choose

Disadvantages

  • As a limited company director, you'll have a number of statutory and financial obligations to HMRC and Companies House; you will be responsible for your company's financial accounts, submissions and meeting your HMRC tax deadlines.
  • You'll also be responsible for the day to day management of your company, including invoicing, record keeping and financial management.
  • There are heavy penalties if tax returns are not filed when due, payments are not made on time or reporting mistakes are made.

It's worth noting that most of the administration and paperwork that arises from owning a limited company can easily be taken on by a specialist contractor accountant; this also greatly decreases the risk of any penalties. But remember that you will always remain responsible for meeting your company's obligations.

Conclusion

The majority of contractors work through their own limited companies for a reason. A limited company offers significant tax advantages and allows you to remain in control of both your business and your finances. However, being the director of your own company raises significant obligations, administration and paperwork. Forming a company may seem daunting for many first time contractors. We recommend using the services of a specialist accountant to take care of the process on your behalf; this will ensure you’re fully compliant from the off and ready to earn as a limited company contractor.

Umbrella companies

When you join an Umbrella company, you effectively become an employee of that corporation. While it's not as tax efficient as using your own limited company, Umbrella's offer a relatively stress-free way to contract. This can appeal to first time or short-term contractors or those who'd rather not take on any form of administration.

How you'll get paid

  1. When you are placed on a contract, you submit the hours worked and your expenses each week to the Umbrella company; this is usually through an online system
  2. The Umbrella company invoices the recruiter or the client directly
  3. You are paid (via PAYE) a salary, after deductions for tax, National Insurance, expenses, the Umbrella fee, and any other pre-agreed costs, by the Umbrella company and receive a payslip
  4. The Umbrella company supplies you with a P60 and a P11D each year as you are an employee of the Umbrella

Advantages

  • You are not a company director and have no responsibility for the financial accounts and tax returns of the Umbrella company
  • As an employee of the Umbrella, they'll collect your money on your behalf from the client and pay you a salary after deducting their fees and any tax due
  • Your legal responsibilities are limited to your own tax affairs, and the risk of incurring penalties for late filing or late payment is minimal
  • Umbrella companies hold the contract with the recruitment agency and therefore handle all the contractual side of the relationship for you
  • They handle all the insurance requirements, accounts, advisers and marketing; you don’t even need to set up a business bank account
  • There's significantly less initial outlay in terms of time or expense compared to setting up your own limited company. There's no company set-up, you simply sign up (enter an employment contract) and you're ready to start contracting

Disadvantages

  • You are not a director of the Umbrella company, you have no control over the company nor the company's accounts and policies
  • 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 these costs
  • You still remain responsible for your own tax affairs including submitting a self-assessment tax return, if HMRC ask you to complete one
  • You are responsible for finding a compliant Umbrella company, some companies offer above-average rates of return and these can later be considered tax avoidance schemes by HMRC; as a contractor you will still be liable for any tax unpaid and any penalties

Conclusion

Umbrella companies offer an alternative to managing your own business. Umbrella's take care of the majority of the administration, leaving you to get on with contracting. The arrangement can be attractive to new or short-term contractors as it requires less of a commitment than having your own limited company. You can join an Umbrella and can leave relatively quickly, whereas setting up a limited company attracts more responsibility through your duties as a director of the company. Umbrellas, however, are significantly less tax-efficient than running through your own limited company.

Number crunching

Comparing the potential take home pay between a limited company and an Umbrella is complicated. It's dependent on a multitude of individual factors such as your work practices, expenses and the costs of an accountant or the fees associated with an Umbrella. Here, we've chosen standard values and set out two examples to compare the tax benefits 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 far greater at the £60,000 level of annual income.

Annual Income £30,000
 LimitedUmbrella
Annual Income £30,000 £30,000
Add Flat Rate VAT Saving £420 £0
Turnover £30,420 £30,000
Expenses £2,400 £0
Accountancy Fees £1,541 £1,500
Salary £8,424 £26,065
Employers NIC £0 £2435
Pre-Tax Profit £18,055 £0
Corporation Tax £3,430 £0
Profit After Tax £14,625 £0
Personal Income Details
Gross Salary £8,424 £26,065
Less - PAYE on Salary £0 £2,843
Less - NIC on Salary £0 £2,117
Net Dividends £14,625 £0
Less - Tax on Dividends £690 £0
Expenses £2,400 £0
Total Income After All Taxes £24,759 £21,105
 
Take Home Pay % 75% 70%
Annual Income £60,000
 LimitedUmbrella
Annual Income £60,000 £60,000
Add Flat Rate VAT Saving £840 £0
Turnover £60,840 £60,000
Expenses £2,400  
Accountancy Fees £1,541 £1,500
Salary £8,424 £52,427
Employers NIC £0 £6,073
Pre-Tax Profit £48,475 £0
Corporation Tax £9,210 £0
Profit After Tax £39,265 £0
 

Personal Income Details

Gross Salary £8,424 £52,427
Less - PAYE on Salary £0 £9,331
Less - NIC on Salary £0 £4,562
Net Dividends £39,265 £0
Less - Tax on Dividends £2,873 £0
Expenses £2,400 £0
Total Income After All Taxes £47,216 £38,534
 
Take Home Pay % 79% 64%

A note on IR35:

IR35 is a complex piece of legislation. Put simply, your IR35 status (which can vary from contract to contract) determines your tax position with HMRC. IR35 runs across every business sector and specialism and the financial impact is significant. If you operate inside IR35, then you will be taxed as though you’re an employee, subject to PAYE and National Insurance; if you're working through a limited company you will not be able to use all of the tax advantages offered. If you operate outside of IR35 and you work through a limited company you can take advantage of the personal allowance and use a dividends model to pay yourself.

It’s often suggested that if any of your contracts are caught inside IR35, you would be better off under an Umbrella. This is because IR35 doesn’t impact Umbrella companies. Contractors working under Umbrellas will already have PAYE tax, and National Insurance deducted from their salaries; as if they were a standard employee, so there’s no additional requirement. However, this leaves many contractors out of pocket.

If your contracts are predominantly outside of IR35, a limited company remains more tax-efficient than an Umbrella. As well as letting you take home more of your earnings, a limited company allows you to flexibly accept contracts both outside or inside IR35. Whereas an Umbrella company would leave you out of pocket for any future work you undertake that’s outside of IR35. But working through an Umbrella would mean that you never need to worry about being caught by IR35.

If your contracts are predominantly inside IR35, there’s a negligible take-home percentage difference between most limited company contractors and those operating under an Umbrella. While Umbrella contractors never need to worry about being caught out by IR35, they will still be missing out on some of the available tax planning opportunities of a limited company.

You can find out more about IR35, and it's financial impacts, here.

Next steps:

Still unsure which option would be best for you? We would strongly recommend seeking professional advice to help you make the right decision on whether a limited or Umbrella company is better suited to your circumstances and requirements. Making the right decision now could help you make significant savings and ensure you’re on the right side of the taxman from incorporation onwards.

Matt Poyser from inniAccountsBy Matt Poyser, who now writes for Listentotaxman.com on matters relating to contracting and limited company taxes.

Matt is a previous contractor with a wealth of experience and the Director of Client Experience at inniAccounts (an accountancy service tailored for contractors, consultants and freelancers).

Have a question? inniAccounts are happy to help Listentotaxman visitors with any queries, simply contact them here.