Umbrella, sole trader or limited company – what’s best for you?

Knowledge base from Boox

By Lynne Gowers on 10th October 2018

Umbrella, sole trader or limited company – what’s best for you?

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.

What type of business is right for you?

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.

What is a limited company?

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.

Find out more about setting up a limited company here.

What is a sole trader?

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.

What is an umbrella company?

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.

Sole trader vs limited company vs umbrella company

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.

Sole trader advantages

  • It is simple and inexpensive to start up
  • There are fewer legal obligations and paperwork compared with running a limited company
  • You can take money out of the business whenever you want to
  • Details of the business are not in the public domain ie. on Companies House
  • You can offset any trading losses against your personal tax bill (going back 3 years)
  • It is easy to close the business if you want to.

Sole trader disadvantages

  • Sole traders have unlimited personal liability in the event that something goes wrong
  • It may not be as tax efficient as running a limited company
  • All of your taxable income is subject to income tax and NIC
  • You will need to provide your own insurance
  • It can be difficult to raise finance as lenders and investors tend to prefer lending to limited companies
  • Similarly, potential clients and agencies may be reluctant to engage with unincorporated businesses.

Get more information about working as a sole trader.

Limited company advantages

  • You have limited liability so your personal finances and assets are protected should something go wrong
  • You can take advantage of certain tax efficiencies
  • Engagers tend to prefer dealing with limited companies, so this can increase your opportunities for work
  • It is easier to sell your business because it is a separate legal and financial entity.
  • It may be easier to obtain start-up capital and financing to grow your business

Limited company disadvantages

  • You need to pay a fee to incorporate the business, although this can be minimal
  • Some people are restricted from registering a limited company – eg. if you are an undischarged bankrupt
  • Company directors have certain responsibilities which come with running the company
  • Details of the company, including its directors are publicly available on Companies House – although the details can be restricted to name and service address which doesn’t have to be at your home address
  • You will need to provide your own insurance
  • Accounting and filing requirements are more complex.

For more on this, see our blog – Sole trader or limited company – what’s right for me?

Umbrella company advantages

  • A very simple way of working – the umbrella company deals with all the admin
  • All your tax and NIC is deducted for you, so you don’t have to worry about putting it aside
  • Ideal if you don’t want the commitment of setting up a business or you are only contracting in the short-term
  • You get the statutory benefits of an employee, such as SSP (Statutory Sick Pay), SMP (Statutory Maternity Pay) and SPP (Statutory Paternity Pay)
  • You’ll be covered by the umbrella company’s Public Liability and Professional Indemnity insurance.

Umbrella company disadvantages

  • You are reliant on the umbrella company to process your wages and pay you correctly
  • The umbrella company will retain a margin for their services
  • Some companies calling themselves “umbrellas” are just schemes to avoid tax and can cost you in the long term if you fall for their promises and HMRC retrospectively closes any tax loophole they are trying to exploit.

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).

What if my contract falls inside IR35?

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/

Tax benefits and differences between limited companies and sole traders

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.

Tax

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.

National Insurance

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).

Accounts and tax returns

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.

Sole trader vs limited company – FAQs

Are there other benefits of being a limited company over a sole trader?

Incorporating your business presents a couple of additional advantages, which are not always obvious:

  • As previously stated, the main benefit in a limited company is the protection of your personal assets in the event something goes wrong. As long as you haven’t been acting fraudulently or dishonestly the company is a separate legal entity to you and your personal liability stops at your share capital and any money you owe to the company – and any personal guarantees you have given.
  • If you anticipate setting up a business in the future, creating a limited company is a cost-effective way to protect your business name, as no two limited companies can exist with the same name.
  • A limited company establishes its own credit rating whereas a sole trader must rely on their personal credit rating to borrow money to invest in their business. This can work both ways – a bad personal credit rating will have no bearing on your company’s business borrowing and likewise if your company has a poor rating it will not impact you personally if you apply for a mortgage or personal loan.

Is there more paperwork involved with being a limited company?

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

Can you decide to go from a limited company to a sole trader?

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.

Can you be a limited company and a sole trader at the same time?

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.

Umbrella company vs limited company – FAQs

Should I use an umbrella company?

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!

Here’s a reminder of the pros and cons of umbrella company working.

What are the payroll differences with an umbrella company?

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.

Is it easy to switch from an umbrella company to a limited company?

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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