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By Lynne Gowers on 10th October 2018
Working as a contractor or freelancer offers flexibility and variety in your working life and once you decide to go down this path, one of the things you need to decide is how to structure your business and pay yourself.
Every business, regardless of its size, must have a legal structure and we are going to consider the three most common ways to work as a contractor or freelance professional – umbrella, sole trader and limited company.
There are many factors which determine which one is right for you, including how much control you want, the type of work you’ll be doing and your long term plans.
If you are starting out, it’s a good idea to make this decision before you start work. You can always change your status later, as you become more established and your business needs change – but that involves additional administration, so it is better if you get it right from the start.
Let’s start with some definitions.
A limited company is a type of business structure which has its own legal identity, separate from its owners (shareholders) and managers (directors). Even if you are a one-person business, acting as director and sole shareholder, the company’s assets and liabilities remain separate from your personal finances.
If you decide to set up a limited company, you can take money out of the company through a combination of a salary and dividends from the company’s available profits. Running a limited company comes with certain obligations and responsibilities to statutory bodies such as HMRC and Companies House.
Operating as a sole trader is the choice of approximately 3.4 million of the UK’s self-employed workforce, not least because it is a very simple business structure that is easy and quick to set up.
As a sole trader, you run your business as an individual and hold self-employed status for tax. This means that you can keep your business’s profits after you have paid tax on them, but also that you are personally liable for any losses the business makes.
As a sole trader, you’ll need to register for self-assessment and file a tax return every year.
An umbrella company acts as an intermediary between you and your agency or client. They are a good choice if you are contracting in the short-term or if you don’t want the burden of administration or chasing invoices.
The umbrella company agrees an assignment rate (or charge-out rate) for your services. This rate includes all the costs of employing you (such as the holiday pay and employers costs) as well as their profit margin.
You are an employee of the umbrella company so all of your tax, pension and NI contributions are deducted directly from your income and you are entitled to statutory employment benefits, such as sick pay and holiday pay.
So, should you simply register as a sole trader or would your business interests be better served by forming a limited company? Or maybe you should just sign up to an umbrella company and let them do the leg work?
To help you understand the options, let’s drill down into the pros and cons of each.
For more on this, see our blog – Sole trader or limited company – what’s right for me?
If you decide that an umbrella company is right for you, always choose a company that operates compliantly and within the tax rules, preferably one regulated by the FCSA (Freelancer and Contractor Services Association).
IR35 only applies to limited companies, so if you choose to operate as a sole trader or through an umbrella company, you will be out of scope of IR35.
If a contract is caught by IR35, all taxable income into the limited company will be subject to “deemed payments”, that is to say deductions equal to employee tax and NI will be applied.
This may influence how you choose to structure your business, but should not form the basis of your decision.
For further help and advice understanding IR35, visit https://www.boox.co.uk/ir35-help/
If you have made up your mind to set up your own business rather than work through an umbrella company, the choices left to you are sole trader or limited company. Considering what tax and National Insurance you will pay will often influence that decision, but should not be the only basis, given the different levels of risk and commercial realities.
Sole traders pay income tax on their business profits by way of an annual self-assessment tax return. The deadline for online self-assessment tax returns is 31st January after the end of the tax year. Find out more about self-assessment.
Income tax bands and rates change year to year. Find out the current tax rates and personal allowances.
In a limited company, the salary you pay yourself as a director is subject to PAYE tax which is deducted at the appropriate rate and paid at regular intervals to HMRC. All company directors are also obliged to complete a self-assessment tax return.
The company pays corporation tax at 19% of its taxable profits – certain expenses which are wholly, exclusively and necessarily incurred (such as salaries and pension payments) can be deducted from the income.
Corporation tax is payable 9 months after the company’s year end and a company tax return must be filed 12 months after year end.
As a shareholder of the company, you are also entitled to receive dividends which are distributed from the company profits after corporation tax.
The first £2000 dividends are tax free, and above that dividend tax is payable through your self-assessment tax return.
Sole traders pay Class 2 NI contributions of £2.95 per week and Class 4 contributions on profits above a certain threshold (£8,424 for 2018/19). At the time of writing, the Government have plans to abolish Class 2 NIC. This is currently on hold until at least April 2019, but Class 2 NIC may well be scrapped.
In a limited company, both Employees and Employers National Insurance (at 12% and 13.8% respectively) is payable on directors’ salaries and bonuses above a certain threshold (£8,424 for 2018/19).
A limited company must prepare annual accounts (also known as statutory accounts) at the end of the financial year. These are filed with HMRC as part of the company tax return. A set of annual accounts must also be sent to Companies House and these can be see by the public – depending on the size of the company the amount of information required in the Companies House version can be very limited .
A limited company must also file an annual Confirmation Statement with Companies House – this includes information about the directors, shareholders and registered office.
Further information about limited company tax can be found here.
Sole traders are not required to keep or file accounts but if you are operating as a sole trader, you will need to keep a record of your income and expenses in order to complete your self-assessment tax return.
Incorporating your business presents a couple of additional advantages, which are not always obvious:
While there is more paperwork associated with running a limited company, it doesn’t have to be particularly complicated, particularly if you use an accounting firm experienced in supporting limited companies. Find out about our services for freelancers and contractors
You can, for example if you want to downsize or simplify your business. A word of warning though, there are certain procedures involved with closing a limited company and these need to be followed correctly.
There will also be tax considerations, for example capital gains tax on cash you extract from the company, for which you should seek the professional advice of an accountant.
Yes, but you will need to be prepared for HMRC to ask questions. For example, you must be able to demonstrate that you are not using the arrangement to avoid tax, such as getting around being VAT registered for one of the businesses.
Using an umbrella company can be reassuring, especially if you are just embarking on a contracting career. All the legal, employment, tax and contractual obligations are taken care of so all you really have to worry about is your assignments. – just make sure you are using a legitimate umbrella company that is an FCSA member..
You’ll also benefit from employment rights and you will be covered by the umbrella company’s insurances.
With an umbrella company, essentially you relinquish control – it is up to you whether you see this as a good or a bad thing!
With umbrella company payroll, the key thing to remember is that there is a difference between the umbrella assignment rate and rate you are paid.
The umbrella assignment rate is the amount paid by the agency or client to the umbrella company to cover all the costs of the services delivered, and the umbrella company’s profit margin.
The pay rate is uplifted by the agency or client to cover all of the costs of employing the worker, including Employers National Insurance, Apprenticeship Levy, Employers Pension Contributions and holiday pay, as well as the umbrella company operating costs and margin.
After these costs have been covered, what is left is the gross pay, from which PAYE tax and Employees NI are calculated and deducted.
It may well be that when you start as a contractor, working through an umbrella company is a great option in the short term. After a while, you may decide that you want more control over your affairs, and possibly look to expand. That is where a limited company may be the solution.
When you leave an umbrella company it’s essentially like giving notice as you would in any employment. Before you leave, you should ensure the umbrella company pays you for any outstanding work and pays out any retained holiday pay. You should also request a P45.
New assignments and contracts will be in your company’s name – you will need to ensure that the contracts you enter into give you the freedom and flexibility you are looking for.
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If you need a little help to find the right accountancy service, don’t worry.
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