Since the introduction of IR35 legislation, there are now only three real trading structures available to contractors: umbrella, limited company or agency PAYE. If you’ve cast off from the shores of the permanently employed to the potentially stormy but nonetheless lucrative waters of freelancing, then you need to stop for a moment and consider which of these three options is best for you before you launch yourself into the deep. It’s important that you set up your new businesses in the best way so that you can minimise your long-term tax liabilities whilst maximising your income and making it easy for your customers to deal with you. This is a highly contentious topic, so let’s have a look at each option in a little more detail.
Option 1 – Umbrella Company (Payroll Service)
Contractors who use umbrella companies are employed by the company which means they are exempt from IR35 legislation. An umbrella company acts as an invoicing vehicle for contractors who want to avoid the administration duties generally associated with contracting, such as issuing invoices, chasing payments from client/agencies, calculating tax and National Insurance (NI) contributions and making payments to their bank account.
Contractors must submit timesheets and records of expenses to the umbrella service, usually through an online portal, and then the rest is dealt with by the umbrella firm. The umbrella firm generate and send an invoice to the agency or client, and chase payment when it is due. Once they receive the money, the umbrella business calculates your tax and NI and transfers your net pay direct to your bank account.
For more information on umbrella companies, it’s a good idea to look on the websites of various enterprises and read through their online resources. Companies like Network One, for example, have some really helpful guides with lots of details on the role, mechanics and benefits of this option.
As you would expect, there is a fee for using an umbrella service. This can vary hugely between different companies. However, for contractors choosing between using an umbrella company or becoming limited, umbrella companies remain an attractive option, providing an easy way to decide if contracting is for you.
Option 2 – Limited Company (or Personal Service Company)
The vast majority of contractors work through a limited company, as this is the most tax-efficient method and enables them to keep more of their income. However, these tax advantages are wholly dependent on whether the contractor falls inside or outside of the IR35 rules.
Setting up a limited company gives you complete control over the running of your company and its bank account. If your contract falls outside IR35 (this means that you’re not deemed to be an employee of the client using a limited company as a disguise), you may draw dividends from the company which are not liable to pay NI contributions.
The aspect of choosing a limited company which puts most contractors off is being liable for the day-to-day administration and the legal requirements which these companies must comply with. Limited company accountancy services do tend to be available, and can be a good middle ground between the two options. However, some of these companies which claim to offer a comprehensive service will try to bill you for a number of hidden charges and exclusions.
Option 3 – PAYE through an Agency
The third option is generally viewed as the least beneficial for contractors. PAYE agencies work by employing contractors. This means that you must pay full tax and NI contributions, and are tied to working through that agency indefinitely or having to resign and join a new payroll scheme each time you change agency. For these reasons, this option is not recommended for most contractors.
The best advice for choosing the option which is right for you is to do some of your own research online or at the library. Shop around for quotes, explore the benefits of different options and calculate the most profitable route for you.