From invoicing to payslips – getting paid as a contractor or consultant is easier than you think.
An introduction to tax
“Choosing the right structure?” You’d be right to ask why you need to bother at all. It’s a straightforward answer: it’s all down to tax, and specifically, making sure you’re paying the right amount.
As an employee, you rarely have to worry about the mechanics of taxes. You turn up for work, your employer pays you, they take care of paying the taxes to HMRC, and you take home your salary.
Behind the scenes, your employer is taking care of paying your taxes. They pay your income tax and National Insurance contributions to HMRC. They also pay their taxes to HMRC (employer’s National Insurance and the apprenticeship levy). And they’ll also make payments into your pension – both your contribution and theirs.
When you start contracting or consulting, when your invoices are paid they are normally untaxed. You can’t just take the money and be done. You need to go through a similar process to an employer, and make sure you’re deducting and paying the right amount of tax before you pay yourself.
That’s why you need an umbrella company or a limited company: it’s a way to take your untaxed income, pay the taxes to HMRC, and then pay yourself.
An introduction to umbrella companies
There are two main ways to handle this untaxed income, by either using a third-party umbrella company or by using your own limited company.
Umbrella companies are simply payroll companies. If you use an umbrella, you’ll become an employee on the payroll of the umbrella company, alongside other contractors and consultants. When your client pays your invoice, they pay into the umbrella company’s bank account. The umbrella company then takes this payment, calculates, deducts and pays to HMRC all the taxes due, then pays the balance to you. They’ll pay it directly into your personal bank account, and you’ll get a payslip. Your tax is taken care of.
There’s a small point to keep in mind. Your client will pay you a gross rate, from which you’ve got to not only pay your employee taxes, but you also need to pay the employer taxes from this. You’re picking up the bill as both employee and employer – and it all needs to come from your contract rate.
If you were a regular employee with a gross salary of £80,000 you’d take home around £55,000 after tax. If you had an £80,000 contract via an umbrella company, you’d take home around £49,000 – you’d be £6,000 worse off. That’s why it’s so important to negotiate a higher rate, because your tax burden will be higher.
An umbrella is very easy to set up, and very easy to use. The main downside of an umbrella is the cost and lack of flexibility. All of your income passes straight through the umbrella, and is paid to you as a salary. Whilst it is straightforward, it does mean you’re missing out on flexibility and the ability to optimise your taxes.
An introduction to limited companies
Another option is to get paid via a limited company. This is a company that you own, and it has its own business bank account. Your client pays your invoice into your company’s bank account. At this point, the money is owned by your company, and you now have the flexibility to decide what you want to do with it. And the amount of tax you’ll pay varies depending on what you do with your income.
For example, you could:
- Hold the money inside your company for a rainy day, or to take 3 months off each winter
- Invest in training courses, certifications, computer equipment & licences to keep your skills current, and to drive up your daily rate
- Invest in building an app, some content or a training course to sell or license to others
- Invest in a company pension
- Buy an office, or invest in residential rental property
- Pay yourself a salary, or pay others a salary to help you run your business
- Pay yourself a bonus as a dividend payment, and share this with your spouse/partner
Each of these options is treated differently when it comes to tax, meaning your taxes will be optimised around your personal situation and goals. Contrast this to an umbrella – an umbrella treats all of your income as pay and taxes as such. It’s this flexibility that makes limited companies so popular.
What about self-employment?
There’s also a third option: self-employment, also known as being a sole trader. When you’re self-employed, you keep track of your income and outgoings and then pay taxes on your profit every year via a Self Assessment tax return. There’s no need to set up a company – you simply need to tell HMRC you’re becoming self-employed.
These days, self-employment is becoming a hinterland. It’s more hassle than an umbrella, but with only a few additional advantages. Legislation change has made limited companies far easier to set up and run, offering you greater flexibility than being self-employed with very little extra effort.
As well as flexibility, there is another significant advantage of a limited company over self-employment: you can minimise your risk should something go wrong. If you’re self-employed, you are personally liable for any problems or debts that arise from running your company. There is no separation of your business affairs and your personal affairs.
Limited liability companies – to give limited companies their full name – offer you much greater personal protection. A limited company is a stand-alone business, which is separate from your personal affairs. This means, should something go wrong, the buck normally stops with the company. If, for example, you deliver poor advice or faulty software, your client can sue your limited company but your personal assets (for example, your home) are protected. This is not the case if you’re self-employed.
Therefore, for most people considering self-employment, setting up a limited company is a far more appealing option.
Are you a ‘disguised employee’?
It all sounds idyllic so far. You can form a limited company, take control of your earnings and optimise your tax position. If it’s so easy and advantageous, it makes you question why anyone bothers being an employee?
The government is very keen to make sure that employees are taxed as employees, and business owners are taxed as business owners. That’s why we have IR35 legislation. IR35 says that if you’re acting like an employee (a ‘disguised employee’), you should be taxed as an employee. This means that if the IR35 legislation applies to your role, you’ll pay income tax and National Insurance on everything you earn, and you’ll forgo the flexibility of managing your income.
Your IR35 status isn’t about you, your job title, or your skills. It’s about the relationship you have with your client and how they choose to work with you. HMRC estimates that overall, two-thirds of contracts are not subject to IR35, and a third are. In our experience, we often see that lower paid, or more junior roles which require greater supervision are subject to IR35. Our clients who are more experienced and work on a consulting basis, with very little supervision, generally find themselves free of IR35. If you’re planning on working via a recruitment agent, do talk to them – they should be able to tell you if the position is subject to IR35 or not.
Summary: when should I use an umbrella company?
Using an umbrella company is right for you if:
- You just want to take home a salary and have limited financial goals beyond this
- You’re going to try contracting or consulting as you’re not sure if it’s right for you
- Most of your work will be subject to IR35 – e.g. you’ll be a ‘disguised’ employee
- You favour simplicity above everything else
- You can’t trust yourself to pay your taxes / to not spend all of your income
Summary: when should I use a limited company?
Using a limited company is right for you if:
- You think you’ll be contracting or consulting for at least a year or two
- You’d like to optimise your earnings and taxes around your personal financial goals
- You’re planning on earning over £30k
- Most of your work won’t be subject to IR35
- You’d like to separate your personal and business affairs
- You’re delivering high value/impact services where you could be held to account for quality, and want to protect yourself from risk
- You’re thinking about employing others, outsourcing work, or using an ‘associate’ model
- You’d like to employ your partner to help with your administration work
- You’d like to make your partner a shareholder to share dividends with
- You need to invest in training, certification or computer software/hardware to deliver your services
- You’re aiming to build something of value to license or sell