Contractors often wonder whether they should work through an umbrella or a limited company. Both business structures have certain advantages and disadvantages depending on the specific needs of the contractor. In this article from Umbrella Search, we explain the differences between the two so you know which business structure is best suited to your needs and circumstances. The article will also highlight the differences in the tax position for each business structure and how their tax positions are affected by IR35.
What is an Umbrella Company?
An umbrella company acts as an intermediary between the contractor and the clients and it effectively contracts with the client as an employer. It also manages the contractor’s administration and financial affairs with its client or via a recruitment agency. It invoices the end client, makes payments to the contractor by deducting PAYE tax and NIC (National Insurance) contributions, and effectively does all the things that a contractor would otherwise have to do. So it provides a comprehensive service that takes care of the back-office aspects of the contract so that a contractor doesn’t have to do that side of things and can focus on the actual job at hand.
What is a Limited Company?
By contrast, a limited company is a completely separate legal entity and one owned and run solely by the contractor. This structure means the contractor has much more control over their financial affairs. The contractor would have to do all of their own accounting, including raising invoices for clients, completing their own annual tax returns and paying their own salary. This allows more flexibility in how income is managed and can enable the contractor to make use of tax allowances that are not available to those working via an umbrella company.
Advantages of an Umbrella Company
One of the most significant benefits of working through an umbrella company is the reduction in administration. The umbrella handles the payroll, tax returns and other financial administration, so the contractor can concentrate on the specialist work he or she is contracted for. This can be particularly appealing to those contractors who are starting out in the world of contracting, or who do not wish to be involved in running a business.
Other advantages include the employee entitlements of belonging to an umbrella company: contractors benefit from pay-related statutory rights such as holiday pay, sick pay and maternity/paternity rights which may offer some financial security and stability not available to pure independent contractors.
But the main downside is the cost. Umbrella companies can cost more than limited companies as they can incur administrative charges and service fees. Take-home pay can also be less than what you could earn through a limited company – and otherwise contractors are taxed in the same way as regular employees through PAYE.
Advantages of a Limited Company
Depending on your circumstances, it may be more tax-efficient to contract via a limited company, particularly for contractors who can pay themselves a combination of salary and dividends. Dividends are tax-free up to a certain level, and the structure of paying yourself as a business owner allows for more flexibility in managing your income – which can generate thousands of pounds of tax savings each year. Contractors also have the ability to claim business expenses such as travel, equipment and training, which can further reduce their taxable income.
A key benefit is the control you have over your own affairs. You are in charge of the invoicing to your agency, who also pays your expenses, makes payments to your pension, and sends your tax payments to the taxman. It sounds simple but, if you are high earner or have a long-term contract, it means that you can maximise your take-home pay and, more importantly, you can run your business affairs the way you want to.
Tax Implications
Tax is one of the major factors to bear in mind when you’re weighing up whether to go down the umbrella or limited company route. If you’re paid through an umbrella company, you’re liable for PAYE and taxes and NICs will be deducted at source. Although this makes tax easy to deal with, it means it’s likely that you’ll end up paying more tax than you would through a limited company.
A limited company can therefore be more tax-efficient (as already noted, there is a flexibility in the mix of salary and dividends that can be paid, while dividends are taxed at a lower rate than income, and a proportion of dividends received are tax-free, an additional advantage is that business expenses can be claimed to reduce taxable income).
The Impact of IR35 Regulations
A significant factor in the umbrella versus limited company decision is the impact of the government legislation known as IR35, designed to prevent the use of ‘disguised employment’. Those deemed to be caught by IR35 are treated essentially as employees for tax purposes, which is a significant factor among those who want the convenience and ease of compliance that is more likely with an umbrella. Conversely, those who are outside IR35 can avail themselves of the flexibility and tax advantages of a limited company.
IR35 has led to an increased focus on examining contractors’ employment status by HMRC. The Revenue has developed a number of new tests to determine whether a contractor is genuinely self-employed or effectively an employee. As a result, contractors need to keep up-to-date on the latest regulations to ensure they are always compliant and able to derive the benefits of their business structure.
Conclusion
There are pros and cons to both options as to whether you work through an umbrella company or a limited company. An umbrella company is more appropriate for lower earners, for example, or people with shorter contracts, who perhaps like it more for its simplicity and all-inclusive nature. But for higher earners or longer-term contracts, a limited company can be more beneficial for tax efficiency and control.
With IR35 changing so often, contractors need to keep themselves informed so that they can make the right decision about the structure of their business. There’s an ease of use and compliance with an umbrella company, and the opportunity to take advantage of tax savings with a limited company, which makes them an attractive prospect for some contractors.
By understanding the differences between them, contractors can select the one that best enables them to achieve their professional goals while also accommodating their personal preferences. Why not give us a call to discuss options available to you?
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