Umbrella Company or Limited Company: what’s best as a contractor?

Still-fresh regulatory changes like the revamp of IR35, plus the incoming increases in both corporation and dividend tax, may have caused some to shy away from contracting.

But for many others, self-employment is still an exciting new world to explore. With 4.35 million people currently working for themselves in the UK, and with skills shortages widespread, the opportunities for new contractors are abundant.

What are the two most popular contractor models?

The two most popular models to consider if you want to work as a contractor are umbrella employment or setting up your own limited company. While there are pros and cons with both options, the former route – umbrella company contracting – lets you avoid some of the regulatory woe mentioned at the outset, while limited company contracting, grants you more freedom and usually, more take-home pay too.

But these are just some of the advantages and disadvantages in play when it comes to the ‘Limited Vs Umbrella’ debate.

Here, exclusively for ContractorUK, Chris James, director of accounting at JSA Group, drills down into the additional differences between these two ways of working as a contractor, while factoring in past, present and future events which may affect your inclination towards each model.

1. Limited company working

What is a limited company?

A limited company is its own legal entity, separate from its shareholders and directors (though you may be one individual acting as both shareholder and director). Your company will have a separate bank account, income and expenditure; can enter into its own contracts, and must pay its own taxes to HM Revenue & Customs.

What about getting paid as a limited company contractor?

Working via a limited company tends to be the most lucrative way to work. As a limited company, you can pay yourself through a combination of salary and dividends, and you pay corporation tax on your profits (rather than income tax). You’re often able to claim a wide range of business expenses too, including equipment, mileage, and business trips among other expenditure. You are likely to have to pay taxes on the money the company pays you, but you have options on the amount you pay yourself, and a say on timing. Both of these can help to maximise the tax-efficiency of working as a contractor, although specialist advice from a chartered accountant is usually required to ensure that efficiency for you is optimised.

The thorn in every limited company’s side: IR35

Reforms to IR35 (which is a piece of legislation first introduced in 2000) were introduced in April 2021.

The original legislation was intended to ensure that workers, who would be deemed an employee if they were providing their services directly to a client (i.e. without a single-person intermediary such as their limited company), suffer broadly the same tax and national insurance contributions as an employee.

These rules were implemented by HMRC to curb tax avoidance. But amid the government’s fears that the rules were inadequate, the IR35 legislation was amended on April 6th 2021 in the private sector (following an amendment in April 2017 in the public sector, which the private sectors reforms are modelled on).

The effect of the rule change is this. Rather than the worker (i.e. you, the contractor) determining their IR35 status -- as was the case pre-April and since 2000, the responsibility shifts (typically) to the end-client. So it is the organisation you supply services to as a contractor who is liable, and the organisation must conduct their own IR35 status assessment in relation to the assignment which you (the contractor) will be going forward for. The end-user (or ‘client’) must then issue a Status Determination Statement (SDS) containing their IR35 status decision, to both the contractor and other parties in the supply chain.

Let’s take a step back from the nitty gritty. Contracting via a limited company (also known as a Personal Services Company) is usually only appealing to those contractors who can compliantly work ‘outside’ IR35 for sustained periods. If you’re outside IR35 it means that, broadly, your behaviour, working practices and contract terms aren’t employee-like.

Some individuals who once worked through their own limited company have found that, now being potentially liable, their end-user does not want to take the risk of getting their contractors’ IR35 status wrong, so will simply not engage limited company contractors, or will place them inside IR35. However, a significant chunk of other end-users have continued to permit their contractors to work outside IR35, assuming the audit of their status by the end-user is in agreement.

On the horizon: corporation tax increases

One main benefit of limited company contracting is that a company pays corporation tax rather than income tax, which is usually at a lower overall rate, helping to maximise take-home pay.

At present, the UK’s corporation tax rate is one of the lowest compared to other countries, having been kept low over the decades to attract investment into the UK.

However, at Budget 2021 in March, chancellor Rishi Sunak announced a rise in the corporation tax rate from 19% (as it currently stands) to 25%, dependent on a company’s profits. Companies that make over £50,000 or more will be required to pay tax at a tapering rate starting at 19% correlating to their income, with those that make a profit of £250,000 or greater (around 10% of UK firms), required to pay the maximum 25% tax by 2023.

In the same announcement, Mr Sunak also unveiled a “Small Profits Rate”, meaning organisations with profits of £50,000 or less will continue to pay the 19% rate. This should mean that about 70% of companies (1.4 million businesses) won’t feel an impact from the tax rise.

Another sting: dividend tax is going up

Unfortunately, this isn’t the only tax rise impacting limited companies.

At Autumn Budget 2021, the chancellor confirmed that dividend tax will also be increasing by 1.25% from April 6th 2022, to help fund a new ‘Health and Social Care Levy’.

This tax increase will impact those who hold investments outside a stocks and shares ISA, investors who have exceeded their dividend tax allowance; and individuals who run their own companies and pay themselves dividends.

While taxpayers won’t have to pay dividend tax on the first £2,000 received in dividend income (due to the £2,000 ‘tax-free’ dividend allowance), anything over this threshold that isn’t held in a stocks and shares ISA, junior ISA, lifetime Isa, or self-invested pension plan (SIPP), will require income tax payments at new rates.

The new dividend rates are as follows:

Basic rate – 7.5% increased to 8.75%

Higher rate – 32.5% increased to 33.75%

Additional rate – 38.1% increased to 39.35%

Although this extra tax may be unwelcome, the government has stated that due to the combination of tax-free dividend allowance and the personal allowance, around 60% of individuals with dividend income outside of ISAs likely won’t be affected by the changes.

It is not yet completely clear if the increase of 1.25% for dividends will be reversed in 2023 when the new Health and Social Care Levy is introduced, as is the case for changes to National Insurance Contributions, which were also announced at the same time.

2. Umbrella company working

What is umbrella employment?

Umbrella contracting is a great way to enjoy the freedom and flexibility of contracting while maintaining access to a wide range of employment rights, protections, and benefits.

It is often the first step contractors take on their journey when they’re not quite ready to start their own limited company, or if an assignment is classed as ‘inside’ IR35.

When you sign-up to an umbrella, you become their employee and receive employment benefits while retaining the ability to work as a contractor. You have a lot less administrative responsibility as all of the mechanics of payment are taken care of for you.

How do I get paid using an umbrella company?

The umbrella will engage contractually with the end-client or recruitment agency it is supplying you into, and will invoice them for its services (i.e. supplying its employee).

From this fee, the umbrella accounts for its costs and retains a profit margin before paying a salary to you, which is subject to income tax and NICs (like any other employee). The various deductions made from the rate paid to the umbrella mean you usually retain less take-home pay than limited company owner-directors, similar to that of a permanent employee.

However, you’ll have access to various employment benefits such as an auto-enrolment  pension scheme, holiday pay, and sick pay. Umbrellas are also useful for building a record of continuous employment, which can be helpful to those contractors considering taking out a loan or mortgage.

Umbrella companies in the headlines

Umbrella companies have faced controversy in the press recently amid fears that workers’ rights aren’t being respected. There is still, at the time of writing, a distrust of umbrellas, as a business model.

However, in our experience, the negative attention really concerns just one or a handful of umbrellas at most. Many umbrellas are operating compliantly and taking care of their workers’ rights. Contractors ought to be aware however -- there are a few non-compliant organisations that have given the industry a bad name, and some ‘schemes’ which masquerade as bonafide PAYE umbrella companies to get individuals to sign up.

Tax avoidance and fraudulent umbrella companies

With the number of contractors using umbrellas on the rise, partly thanks to IR35 being updated, HMRC is keen to ensure umbrella companies are working compliantly and taking care of workers as they should be.

Over the past year, we have seen HMRC take some steps to clamp down on umbrellas who are really just businesses operating tax avoidance schemes in which workers are promised higher than usual take-home pay rates. These non-compliant ‘umbrellas’ entice clients with these promises, then disguise payments using ‘loans’, ‘bonuses’, or other non-taxable payments to avoid paying the correct tax for the worker.

One simple rule of thumb contractors can use to steer clear of such underhand operators, is that if a company is offering huge tax savings or extremely high take-home pay rates (such as 80-95% of the rate paid to the umbrella), it’s most likely a scheme ; is ‘too good to be true’ (a phrase HMRC likes to use), and should be avoided.

Interestingly, just before Autumn Budget 2021, HMRC outlined new advice on how to avoid getting caught up in disguised remuneration schemes. Because of this, and a government promise to set up a Single Enforcement Body to eventually regulate umbrella companies, we expect to see increasingly tighter legislation to govern umbrellas at some point in the not too distant future.

Mini-Umbrella Companies

Mini-Umbrella companies are also on the government’s radar, and for good reason!

These companies are set up with an ‘outsourcing’ or ‘promoter’ business that has other linked businesses within its operation to complicate the supply chain and facilitate fraud.

The promoter business typically presents itself as a large umbrella company. It then has a collection of mini-umbrella companies (usually limited companies) that employ and pay 1-3 workers, enabling the directors to make use of HMRC’s National Insurance allowance and reduce their PAYE and VAT payments. Often, the promoter business will set up unwitting overseas workers as the directors of these mini-umbrellas, making it virtually impossible for HMRC to track them and chase for unpaid tax.

Getting involved with these kinds of companies can mean you lose out on take-home pay and may face financial penalties from HMRC, even if you weren’t aware of the relevant individuals’ actions! So, it’s massively important when choosing an umbrella company that you receive a clear pay illustration (N.B ask the umbrella for a Key Information Document, although note you should receive one automatically). Remember, when using a brolly, you want to have transparency from the umbrella regarding your pay; your rights and how these rights are going to be made available to you. You also want to have transparency on all the parties in the supply chain – again, to protect yourself.

To sum up...

There are pros and cons to both umbrella employment and limited company contracting, with ever-changing regulations adding confusion and controversy to the market. The ‘nuts and bolts’ for workers to consider are more numerous than ever before. But it’s not all doom and gloom!

The self-employment and freelancer sphere is on the brink of rebounding as the recovery from covid matures, and it’s set to be a large economic contributor to the UK. In fact, according to a report in May, 60% of UK businesses say they plan to increase their use of freelancers over the coming months – helping them access the talent they need without the expenses of permanent employment.

So although tax rate changes for PSCs may feel punitive, and umbrella employment can seem complicated, these issues shouldn’t outweigh the positives of contracting -- the additional freedom and flexibility to manage your time and do more of what you love, controlling when, where, and how you work.

Finally, a recommendation

Our view is that ALL the advantages of contracting still exist; you just have to be more vigilant and on top of your game to make them work for you. No matter which working model you choose, make sure you work with a trusted, transparent accountancy partner or umbrella payroll provider, both of whom can help you stay up-to-date with regulatory changes and navigate them as they happen. This will help keep you compliant; on HMRC’s good side and for yourself -- help you maximise take-home pay while minimising risk.