Contractors’ Questions: Is it better to be a contractor or an employee? The pros, cons, and finances

Contractor’s Question: Probably an impossible question to answer objectively (not just because you’re a contractor website), but is it better to be a contractor or an employee, in terms of the pros and cons -- and the finances?

Expert’s Answer: Many people believe that contractors receive large tax advantages over employees.

However, considering the absence of employment rights for contractors and the security that many employees have, it’s not always clear in every case whether the financial benefits and flexibility of being a contractor will always be worth it.

Financial benefits of being a contractor

Let’s look at an example of the financial benefits that a contractor may have over an employee:

Applying the tax rates for 2020/21, an employee earning a salary of £60,000 will take home £43,443. The gross cost to the employer after considering Employer National Insurance of £7,067 is at least £67,076.

A contractor operating through a PSC/limited company undertaking an outside IR35 contract, with the same earnings of £60,000, could take home £48,245, which (versus the employee route) is an increase of £400 per month.

The contractor can also negotiate a better rate and increase their earnings further, as the end client’s costs related to Employer National Insurance, pensions and holiday pay is not applicable.

The main factors that make contracting more financially attractive

In addition, as most PSC contractors will likely tell you, the financial advantage mainly stems in from two factors:

1. Optimum level of salary and dividends

Contractors running their own limited company/PSC can choose to pay themselves a lower salary, usually up to (and crucially not above) the NI threshold, with the rest of their funds drawn as dividends. There are no National Insurance contributions due on dividends, therefore the contractor pays no National Insurance on the £60,000 income described in the example above, whereas an employee (on that sum as salary) is required to pay £5,060 in employee national insurance contributions.

2. Flexibility in claiming expenses

Limited company/PSC contractors are permitted to claim expenses that are “wholly and exclusively” incurred for business purposes. This gives contractors a significant advantage over conventional employees, because the expenses are tax-deductible and hence, they come out of the contractor’s pre-taxed income.

An employee, on the other hand, must bear these costs from their post-tax earnings.

Example: Assuming both spend £500 on travel and lunch, for a basic rate employee the cost is £735 (grossed up by 32% -20% personal tax and 12% employee national insurance), as it comes from their net earnings after tax. For higher rate employees, the cost is higher as they pay 42% in tax and NICs, resulting in a total cost of £862.

On the flip side, for contractors, the cost can be claimed through the company, so they primarily save on 19% corporation tax at £500, which amounts to £95 in savings. There are further savings for contractors so here they don’t have to pay tax on dividends, so a basic rate taxpayer saves an additional £30 (£405*7.5%), therefore the net cost to them is just £375.

For a higher rate taxpayer, the savings are much larger as they save an additional £132 (£405*32.5%), resulting in a net cost of just £273.

VAT for contractors

For items that include VAT, the contractor can offset this against their input VAT charged on their invoices. So, if a contractor purchases a laptop at £1,000 (including VAT), the cost to them is potentially only £675. (N.B. This is because they can firstly recover the VAT costs of £167 (£1,000/6) and as the expense is wholly and exclusively for business, they can then save corporation tax of £158 -- £833*19%. So net cost = £1,000 – £167–£158 = £675).

Contractor ‘charge out’ rates, or pay rates (daily or hourly)

An average contractor ‘rate’ of pay generally is much higher than that of a full-time employee, partly as the client is not required to pay holiday pay, travel, sick pay, pension contributions or any employee benefits. This alone, without the benefits via tax can make contracting more financially-attractive to many. The higher rates commanded by contractors (who tend to specialise in an area and be highly skilled, thereby further justifying the ‘rate’ trumping a standard worker’s ‘salary’) has long been seen by some as an appropriate pay-off to cover the risks associated with being self-employed and the absence of employee benefits.

Corporation Tax for contractors

To everyone’s surprise, in the recent Budget 2021, the chancellor decided not to raise Corporation Tax. However, it’s worth remembering that contractors with profits over the small profits rate of £50,000 will be caught by what Rishi Sunak did announce -- a new corporation tax increase from 2023. But positively for you if you’re leaning towards contracting, with the help of tax planning, such as contributing to a pension, contractors could be able to still enjoy what will be called the Small Profits Rate – a 19% rate of CT, which they pay currently.

Remember the other benefits of contracting

For many, being a contractor is not just about the possible financial benefits, but also the freedom and flexibility that contracting can bring to their life. As a bonafide contractor, you have the freedom to work when you choose, where you choose and for however long you choose. For many, this is a bigger motivator than just the potential financial perks.

IR35 changes on April 6th 2021

The off-payroll IR35 reforms may make you consider your future as a contractor versus employee. The reforms shift the responsibility of assessing the employment status of a contractor to the end-client and most importantly, the underlying tax liability too.

If the status is assessed incorrectly, the tax liabilities and HMRC penalties could be very punitive, and so blanket assessments have inevitably been made, as businesses look to avoid risk and costly mistakes. Before making any decision on your future as a contractor, you would need to talk to your client about these reforms. You’d need to make sure you know what IR35 status is correct for you and gather evidence to support that status.

Many aren't ready, but are you?

Potentially off-putting if you are unsure if you want to be a contractor, a survey conducted three weeks in advance of the April 6th launch date found that more than one third of medium sized businesses affected by the IR35 reforms (large businesses are affected too while ‘small companies’ are to be exempt), are still not ready.

If you are a limited company contractor working under the new IR35 rules from April 6th 2021, then you will likely want to consider whether you are better off, financially, being an employee, such as of an end-user or working through a PAYE umbrella company.

Fundamentally, those caught by IR35 (also known as inside IR35) are treated like an employee, with their tax status the same as an employee but without any of the rights, plus a loss of some of the contractor-related financial advantages outlined above.

For example, rules around business expenses for contractors working inside IR35 are strict. So, you won’t be able to claim for things like travel to and from work, or subsistence, if your contract is inside IR35.

Using an umbrella company

As contractors risk being deemed as inside IR35, they may find themselves interested (or compelled) into working via an umbrella company. Umbrella companies are often regarded as a ‘halfway house’ between employment and contracting. Umbrella companies employ workers under an employment contract with all the statutory employment rights, deduction of employment taxes, costs for their insurance. Compliant umbrellas do this while giving the worker the flexibility and freedom they get while contracting and working at different workplaces on a temporary basis.

Some people regard using an umbrella company as giving away important aspects of control, as the umbrella becomes your employer. But equally, other say ‘brolly working’ can make life simpler, with less paperwork, and less worry (about IR35 among other things). And both of those can give a contractor more freedom and room to concentrate more on different types of rewarding or interesting work.

So, is it better to be a contractor than an employee?

As you’ve hopefully worked out by now, the answer to this question depends on many factors, including what you value, personally, as an individual. You need to consider financial benefits, freedoms, flexibility, and your appetites for risk and security.

Using an umbrella company won’t give you the same financial benefits as contracting through a limited company. However, umbrella companies can be ideal for people who are giving contracting a go for the first time or for those contractors wanting to ‘dip their toe in the water’ of employment once more.

We tend to find that when you look at the figures overall, being a contractor can still offer a better financial return than being an employee. Add to that the other non-financial benefits, such as freedom to choose a lot about your work and the instant flexibility to more readily achieve a suitable work/life balance, and contracting will remain an attractive option for many people, despite IR35’s best efforts.

The expert was Siddharth Agarwal, tax director at DNS Accountants.