Limited company or umbrella? What’s the best option for you?

limited or umbrella

Umbrella companies have been firmly in the news as of late – from Jeremy Corbyn’s labour party manifesto pledging to ban ‘payroll companies sometimes known as umbrella companies’ through to Unite’s (the UK’s largest union) recent call on the NHS to outlaw ‘parasitic brollies’.

Following the IR35 application changes in the public sector, our recent conversations with recruitment agencies and public sector parties has shown a shift in their recommendations to contractors. Many now appear to be applying pressure for contractors to jump ship from their limited company into the conglomerate of an umbrella. We’re not alone in our findings. A survey of more than 1,500 contractors by ContractorCalculator found that of the contractors who chose to leave the public sector after the IR35 application reforms came in, 17% did so after being told to use an umbrella company.

But are these requests in the best interests of independent professionals? Or the result of knee-jerk, risk averse reactions?

We take a look at the reasons why your limited company remains the best option for you.

What’s the difference?

‘The majority of contractors work through their own limited companies for a reason. The tax advantages of working this way outweigh any other compliant method and you remain in control of your own finances. Umbrella companies offer higher risk and lower tax efficiency than limited company operation.’
– Rowena Barnwell, FCCA – inniAccounts Director of Client Services

Limited companies

Simply put, with a limited company you are the director of your own private company. You have complete autonomy of how you work and who you work with. As a director you are fully in control of your own business and its financial affairs – this allows for greater opportunities for tax planning including drawing dividends, claiming expenses and making pension contributions. The downside? While you have the pros of being a director, you also have the additional responsibilities to HMRC and Companies House; which of course includes paperwork and financial management. This problem is easily solved however by appointing a specialised contractor accountant – which typically costs a set monthly fee equating to around £1200 a year.

Umbrella companies

When you join an umbrella company, you effectively become an employee of that corporation. You’ll receive a salary that has been subject to PAYE tax and National Insurance. The fact your payments are being handled by a second party naturally introduces a level of risk; as you are reliant on the umbrella collecting money from your client or agent and using it to pay you.

Most reputable umbrella companies cost around £30 a week (£1,500 annually). However, there are usually additional costs associated. Services levied by umbrella companies can reach as much as 9% of the value of a contract, and many insist on contractors agreeing to a minimum level of charging or billable time; meaning the price can fluctuate (unlike accountancy fees which use set prices regardless of turnover). The benefits? Your financial affairs are handled by the umbrella; so there’s less paperwork and financial management. Most weeks you’ll merely be submitting a timesheet, and the company will manage the rest. However, this means you’re missing out on any tax planning opportunities.

Take home pay
Assuming all your contract work is outside IR35 and your annual gross contracting income is around £55000 (with £1200 spent on either accounting fees or umbrella services). Your typical annual take home pay from an umbrella company will be around 65% of your income. With a limited company, this increases to approximately 76% – this is before you even begin to factor in expenses, pension contributions and the many other tax planning benefits available to limited companies.

What about inside IR35? Or when working with the public sector in general?

It’s important to remember that working in the public sector doesn’t necessarily mean your contract will be inside IR35 (several of our own clients have contracts with HMRC that are outside IR35). HMRC specifies that public authorities must assess their contracts on a case by case basis and not mandate IR35 across the organisation or insist that everyone uses an umbrella company. Unfortunately, this wasn’t necessarily the case following the introduction of the changes.

‘Knee-jerk reactions and blanket bans’

‘When the public sector changes came in April the onus shifted from the contractor to the end client, many of whom were purchasing teams in public sector bodies with little understanding of IR35 and the extra processes involved. Many saw the new obligations and tax risks and resorted to short-sighted blanket bans. Such as the NHS deeming all contractors automatically inside IR35 and stipulations that all contractors have to be in an umbrella company.

These knee-jerk reactions were bad for everyone and unfortunately either saw contractors shifting to umbrella corporations as they were told or sticking with what was best for them and voting with their feet by leaving the public sector. Thankfully most of these decisions have now been repealed. Public authorities, like the NHS, will be examining contractors on a case by case basis as intended. But there remains plenty of misinformation both within the public sector and with contractors.’
– James Poyser – CEO of inniAccounts

So why were public bodies and recruiters trying to push contractors towards umbrellas? In short, IR35 doesn’t impact umbrella companies. Contractors in umbrellas will already have PAYE tax and National Insurance deducted from their salaries; as if they were a standard employee. It’s clear why this would appeal to in-house purchasing teams and recruiters. Instead of having to assess IR35, make the necessary deductions if required and have a potential tax risk if mistakes are made, umbrella companies simply remove this additional requirement. It’s a simple and risk averse approach. The problem? It assumes a one-size-fits-all approach that leaves many contractors out of pocket.

Take home pay
Assuming all your contract work is inside IR35 and your annual gross contracting income is around £55000 (with £1200 spent on either accounting fees or umbrella services). Your limited company take home will decrease to approximately 61%. As such, you may find there are marginal gains from working through an umbrella. However, if only half of your income comes from contracts inside IR35 your limited company take home increases to approximately 69% – not including the many tax planning benefits available to limited companies.

For those independent professionals whose contracts are not permanently inside IR35, a limited company outweighs the benefits of an umbrella. As well as remaining more tax-efficient, a limited company allows you to keep risk-free control over your business and to flexibly accept contracts both within the public and private sector; outside or inside IR35. Converting to an umbrella company would mean that any future work you undertake outside IR35 would leave you significantly out of pocket. The fairly negligible percentage difference even for those who predominantly work inside IR35 may also not be worth the higher risk associated with umbrellas or losing out on many of the attractive incentives a limited company still offers (such as being in complete control of your own time and work choices).

The rise of non-compliant umbrellas

Confusion around the public sector changes and the following risk averse reactions have unfortunately seen a rise in ‘dodgy’ non-compliant umbrella companies. The Freelancer and Contractor Services Association (FCSA) claimed ‘We warned HMRC that this would happen. Contractors are always looking for the best deal, and many are being enticed by umbrellas promising a high return on their income.Many umbrella schemes are promising unrealistic tax savings. Here at inni, we’d advise the age old adage – if it appears too good to be true, it probably is. On the other hand, some umbrellas are taking far larger cuts than contractors were originally expecting. Unite’s recent attack on umbrellas stems from its claim that contractors in the NHS are losing ’46 pence in the pound of eligible earnings’.

While not quite to the extent of the Labour party’s banning intentions in their manifesto, umbrella companies haven’t historically had a fan base with the conservative government. When looking ahead, it’s worth noting that they’ll likely see further clampdowns.

We firmly believe that limited companies remain the best option for contractors, but if you do decide to make the change to an umbrella, we’d advise doing your homework to ensure they’re compliant.

Staying limited

As an independent professional, it’s important to continually assess the options that best suit you. The IR35 public sector application changes and the initial reaction from public sector bodies has seen wide spread discussion and growth of umbrella companies. Confusion and misinformation are still rife whenever talk of IR35 is raised. This has unfortunately seen a rise in bad practices from both the public sector and umbrella companies.

While umbrellas remove any question of the ‘dreaded’ IR35, for many contractors (especially those who only occasionally work inside IR35), they simply can’t compare to having your own limited company. Limited companies remain the most viable option for keeping control of your day to day business, managing your finances and returning home with more in your pocket; all while easily remaining compliant with HMRC with the help of your specialist accountant. The tax advantages of working this way continue to outweigh any other method.

So, what can we as contractors do to stop the spread of misinformation? First and foremost, we can help to educate our clients; ensuring appropriate and accurate IR35 decisions are made going forward. Next week we’ll be taking a look at how the IR35 application reforms have impacted the future of public sector contracting. We’ll also be examining how you can facilitate conversations with your agency or client to help manage any confusion over IR35 and confidently negotiate your contracts.