Tax Basics for Contractors
Our Guide to tax, VAT, NI for Contractors, including tax saving tips.Fri, 25 Oct 2013
Please note that this guide is now of out date and has been replaced by our Beginners guide to contracting through a limited company, as of May 2020.
Here we outline your basic tax options and requirements as a contractor and what returns you need to make as a limited company. We also highlight ways that contractors can make tax savings.
What type of Contractor are you?
Your decision on whether to set up as a limited company or go with an umbrella company structure has a significant impact on the amount of tax returns you need to make. Using an umbrella company means filing a lot less tax returns.The downside to an umbrella set up is that you are effectively a PAYE employee and excluded from any tax saving techniques afforded to a limited company setup. If you have gone down the ltd company route, read on for an overview of your tax, vat, NI obligations. Taking on the extra paperwork and filing requirements involved with contracting through a limited company can have significant tax saving benefits for a contractor. You can offset a lot of the work load by appointing a specialist adviser or contractor accountant to look after the companies filing obligations. In many cases the limited company structure offers the potential to take home, on average, 15% more earnings than the umbrella structure. For help on deciding which structure best suits your position, see our other Guide on Limited Company v's Umbrella Company.
Your first step will be to register your Company with Companies House, which can be done online here www.companieshouse.gov.uk/webfiling/demoVideos/index.shtml
Once you have registered with Companies House, you will receive your Companies House password and code. You then need your Government Gateway password and username allowing you access to HMRC's online services. Most returns made to HMRC will be made online. In order to complete your returns online you need to use your Government Gateway password to register with HMRC for individual returns, eg. VAT. This should be done promptly to avoid any delays in making timely returns and incurring fines. At the bottom of this guide you will find a list of steps you need to take in order to register for all relevant taxes.
Annual Returns & Corporation Tax
You need to make two different sets of annual returns to both Companies House and HMRC. These returns need to be made regardless of whether your company made a profit or not. If your business qualifies for the Small Business Exemption you may not have to get your accounts audited, which will save you money. Most small companies will qualify for this exemption. Here for more on the audit exemption.
Companies House require your Annual Return and your Annual Accounts. Failure to make them is a criminal offense. Your Annual Return is due 12 months and 28 days from the anniversary of the last Annual Return or the date of incorporation (for the first return). It gives details on your company such as shareholders, directors, etc.
Annual Company Accounts, different to the Annual Return, are required by law to be submitted to Companies House each year. They are due 9 months after the end of your company accounting period (ARD).
Failure to make your Annual Return and Annual Company Accounts on time can have negative effects on your companies credit rating and result in your company being struck off. Companies House apply hefty fines for late returns so make sure to keep up to date. It is advisable to get help from an accountant in completing your annual returns and accounts, as they can be quite complicated and mistakes could prove costly.
HMRC &Corporation Tax HMRC require your Corporation Tax Return (CT600) and your Company Accounts, both due 12 months from the end of your company's year end. A late return will see a minimum fine of £100, which can rise dramatically as the fine will be a percentage of the tax owing and penalties for regularly late returns.
Making your Corporation Tax Return and actually paying your Corporation Tax are two different returns. Your Corporation Tax payment is due 3 months before your return is due, ie. 9 months after your company's year end. Late payment will earn penalties where interest is calculated on the amount owed.
Whatever earnings you do not take out as a basic wage or pay expenses will be deemed company profits and subject to Corporation Tax. The after tax company profits can then be paid out to the contractor as dividends. Tax owing on dividends is collected through Self Assessment, see below.
Taxes & Self Assessment
If you take a basic salary of anything up to your Personal Tax Free Allowance, and the rest in dividends, you will be paying any income tax owing on the dividends through end of year Self Assessment. Once your total annual earnings, including any other income, share dividends or interest from savings, have exceeded the higher rate tax threshold (your tax free allowance + £32,010 for the tax year 2013/2014), you will be subject to income tax at dividend rate. The tax you pay is at a reduced (dividend) rate as HMRC assumes tax has already been paid on the dividends in the form of the 20% Corporation Tax, taken before the dividend was paid. An extra dividend tax credit of 10% will be applied by HMRC as a result. The tax owing will be collected through your self assessment return. Working out exactly how much you owe if you go over the higher rate tax threshold is a complicated affair, and one better left to your accountant.
Your online self assessment return is due on the 31st of January each year. Any tax owing is also due to be paid by the 31st of January. Hefty fines follow both a late return and late payment of any outstanding tax. You must make a self assessment return each year even if the tax owing is nil. Do not be tempted to be late with either the return or the payment of tax owing. See our article for a complete breakdown of late Self Assessment penalties and fines.
Once you receive your Government Gateway password you can log onto HMRC online services and register for VAT.
One of the advantages of contracting through a limited company is that you can use the flat rate VAT system. This system greatly reduces the amount of time spent on VAT related book keeping as it allows you to pay VAT at a lower rate than standard, discounting it by a set percent for presumed VAT on purchases. While on this scheme you generally do not claim back VAT on purchases, although you may be able to claim back the VAT on capital assets worth more than £2,000. The percentage of VAT you pay differs depending on the type of business your company is. You will also receive a discount of 1% if it is your company's first year being VAT registered.
For example, an IT Contractor will pay 13.5% VAT in the first year and 14.5% in the second. See HMRC for a list of which rate applies to which business and more on the flat rate scheme.
Once registered, you need to make a VAT return each quarter, even if it is nil. If your return is late (you get a 7 day grace period if you file online), you will be in default. HMRC will then send you a 'Surcharge Liability Notice' explaining that there will be no fines as long as you send in your VAT return and are not late with any other VAT returns in the next 12 months. If you default again during this 12 month surcharge period, you may also have to pay a 'default surcharge' on top of your outstanding VAT. This is a percentage of your unpaid VAT at the due date. For more information on this surcharge see HMRC here.
If you decide to take a minimum wage under the National Insurance 'Primary Threshold' and take the rest as dividends, or as some do, take no salary and all income in dividends, you will not pay any NI. If you are under an umbrella company structure you will pay both employers and employees NI. A limited company structure offers substantial NI savings to a contractor.
If you trade as a limited company you will be treated as an employee of that company for NI purposes and liable for Class 1 NI if you go over the primary threshold.
It should be noted that making no NI contributions at all can negatively affect your entitlements to a state pension and other state benefits. There is a way to get around this problem though. The Primary Threshold (PT) at which point you begin to pay NI is £139 per week, but once you earn over £102 a week, the Lower Earnings Limit (LEL), NI begins. If you keep your weekly salary between these two figures, technically (if not ethically) you will earn your NI credit without paying your contribution.
Basic Tax saving tips for Contractors
- The first and most effective tax saving tip is to make all your returns and payments on time. Late filing and payment penalties by both HMRC and Companies House are brutal and completely avoidable by making timely returns.
- If you know your annual earnings are to go over the higher income earnings rate, put money aside throughout the year to pay your year end tax bill. Opening a savings account and earning some interest off this tax owing can be a small extra benefit to being prepared for your tax bill.
- Choosing the Flat Rate Vat Scheme can save a contractor money, even earn them interest from extra money in short term savings accounts. You can get to keep an extra 1% of VAT charged in the first year.
- Making full use of all annual Personal Allowances, such as tax free savings allowance, pension contributions, childcare vouchers, can sometimes mean the difference between passing into the higher rate tax bracket at the year end or not. Also look at past years pension allowances- if they have not been used in full, you may be able to carry them forward and use them to reduce the gross income total for self assessment purposes.
- Contractors working under a limited company can claim many expenses as business expenses and pay for them out of gross earnings, using them to lower their tax bill. If you are not using the Flat Rate VAT Scheme, many of these expenses can be used to reduce the VAT bill also. Examples of allowable expense are computers, laptops, books, training courses, etc. Also, if you work from home, you can claim a certain portion of household bills as business expenses. HMRC have info on the working from home allowances.
- Get a reputable specialist Contractor Accountants on board. These specialise in dealing with limited company contractors and are well worth the fees they charge for their expert advice and services.
Limited Company Structure offers Contractors Flexibility
- How to get paid: Contractors have the choice of paying themselves a wage of up to a certain amount and then the rest in dividends. How much they receive through each method can be changed around to suit their particular needs. Points to consider are the implications on NI payments, as mentioned above in the NI section in this guide, and also the implications of taking a low salary /wage. Salary is associated with the maximum tax allowable value of personal pension contributions, so keeping it low will impact your allowable tax free personal pension contributions. A solution to this is that company pension contributions are not restricted by the salary received.
- Timing when you receive your dividend payments. Having the control to decide when you receive your dividend payments can help reduce your tax liability. Changing the date by a week or so in April can take a payment from one tax year into another, depending on what is more tax effective. See our side column on the timing of dividend payment dates for more.
- Not all dividends are paid in cash straight away. Sometimes declared dividends are shown as a loan due to the shareholder (director) when they want to take the cash at some future date, or used to effectively “repay” amounts already taken from the company. This can be used to access dividends in one tax year while passing the tax liability for them into another tax year. You can use director’s loans as a means to take the money when you need it and then declare a dividend to be payable by offsetting it against the loan taken. So long as this dividend is declared and paid within 9 months after the end of the accounting period you won’t have to pay the tax on an overdrawn loan account (there is always the issue of the interest free benefit in kind to consider). But you can use the time lag to make the dividend fall into a later tax year and defer the higher rate liability. The same technique can be used if ever you want to defer taxable income from one tax year to another; but be careful … it’s very easy to stockpile higher rate tax liabilities if you do not monitor this closely.
- VAT: You have a choice whether to be part of the Flat Rate VAT Scheme or not, depending on which best suits your business.
- Pension Contributions: With a limited company you can choose to make company pension contributions of up to £50,000 per year as payments are not linked to salary amounts as personal pension contributions are. Company pension contributions can be a useful tool in reducing end of year income tax liabilities, particularly if they bring earnings down into a lesser tax bracket. However it is best to talk to an independent financial adviser before proceeding.
What you need to register for:
- Register your company with Companies House to get your password enabling you to file returns online.
- To get your Government Gateway username and password for making annual returns to HMRC.
- Once you have your Company Gateway Number you can log on to HMRC online services and register for VAT, PAYE, Corporation Tax, etc.