What is your financial profile, and how to calculate it as a contractor?

A quick online search for ‘The financial profile of a contractor’ gives results ranging from ‘try our net-income-after-tax calculator’ to ‘accounting definitions on your balance sheet.’ 

A deep dive is usually safer, shrewder

But to fully understand the financial profile of a contractor, it’s necessary to delve into the individual's circumstances, including their immediate family as well as their business aspirations, and where they stand in the timeline of achieving those goals.

And so to provide the best possible advice to a contractor asking for their financial profile, a professional adviser should therefore seek more than mere accounting information and a quick calculation of net income, writes Steve Crouch, founder and CEO of Auderli.

The normal driver for financial aspiration is to increase one's net worth. That is -- all assets (business and other) less liabilities.

Your property, not your PSC – not that your PSC isn’t key to your financial profile

As a contractor, it’s likely that your home is the biggest asset, not the assets of your Personal Service Company (PSC). The value of the PSC will most likely include only the cash in the bank and monies owed to it after settling its liabilities.

At this stage, you might understandably ask:

How does one increase net worth?

Well, you can do so by maximising net profit which will inevitably mean trying to minimise the tax take; then accumulating, and then obtaining higher growth from other investments. 

In the current inflationary climate of uncertainty, with ever increasing costs associated with energy and food, it’s important to ensure that you are working through the right structure so you can minimise deductions for tax.  

For the contractor running their business through a PSC, there is no better time to ensure that you extract monies from the company in the most tax-efficient manner. If personal tax is being paid at the higher rate, this strive for tax-efficiency could include potentially gifting shares to your partner if they have availability of their personal allowance and/or basic rate band, in order to benefit from dividends. This move can also allow equalising income so as to minimise the effects of clawback of income (such as Child Benefit).

Working from home? Here’s how to trump the HMRC flat rate

If you are required to work from home, then consider licencing your company to use certain rooms in your home for the working week and charging a suitable rent. This rental income would need to be declared on the personal tax return, but the expenses that can be claimed are less restrictive than under employment.

The current increases in costs, particularly energy costs, could then reduce the profit to nil. If the property is owned jointly, then the rent would be declared on your respective tax returns -- again potentially utilising lower rates. The rent cost in the company accounts is then likely to be at higher deduction than the HMRC flat rate of £6 per week for ‘use of home’ as office.  

Conversely, those contractors who amid covid restrictions lifting have been asked to go back to the client site, will need to ensure they cease claiming the additional expenses. Particularly as it’s understood that HMRC may challenge future claims.

Limited company liabilities, reserves, loans

But if you are a contractor limited company with reasonably substantial reserves, consideration could be given to investing in some other venture or investment. Remember, it isn’t necessary to withdraw personally from the company and incur tax charges. And it’s permissible for a new company to be formed and an inter-company loan be made, thereby avoiding the personal tax charge and ring-fencing in a new entity. 

With a new limited company or an existing one, care should be given both to the new rate of corporation tax (potentially increasing for your company to up to 25%), and the £250,000 profits threshold being split among associated companies. But the reality is that many contractor PSCs will not exceed £125,000 in profit. Where the threshold is split between two companies, the small company rate of 19% corporation tax can therefore be maintained. 

Separating out any large reserves of cash and investing in a separate company could also take care of potential issues in qualifying for Business Property Relief (BPR), for the shares in the PSC, on the death of the contractor, thereby minimising Inheritance Tax (IHT). Care also has to be taken to ensure BPR is not affected by directors’ loans. Monies owed to the director would not qualify for BPR unless properly documented as a “security” (loan notes or debentures). 

Considering the ends

Individuals who are considering closing down their PSC using the Members Voluntary Liquidation route, should be careful to ensure that a partner holding shares would fulfil the Business Asset Disposal Relief criteria. If not, then transfer their shares back prior to liquidation. If the two-year qualifying period is already met by the transferee, any additional shares would fully qualify.

Also, it is extremely important to ensure that you have a properly drafted will in place. Financial profiling will enable the will-writer to properly consider the tax position and ensure IHT is minimised on death. Otherwise, an unmarried partner could be substantially disadvantaged, as joint assets would automatically pass. However, any other assets would pass under the rules of intestacy. Unmarried partners not holding assets jointly would not inherit and would otherwise have to make a claim to the courts, at the worst possible time.

Finally, and not just because it seems an appropriate note to conclude on, dying without a will can also lead to complications that could so easily have been avoided, especially if you are married or in a civil partnership. Financial profiling for the contractor is therefore extremely important to avoid if not minimise unwanted consequences.