A Guide to Tax and NI for Contractors

It was Benjamin Franklin who famously said “in this world, nothing is certain but death and taxes”. Although this is undoubtedly a morbid take, taxes must be paid when you earn and it’s important that as a contractor you understand your tax obligations and ensure that you meet them.

In recent years many people have made the move from employment into the world of contracting. Tax is of course relatively simple for traditional employees with their income tax and National Insurance Contributions deducted at source through Pay As You Earn (PAYE). But contractors have more financial responsibility as they must ensure they meet their tax obligations.

Handling bookkeeping, accounting and tax returns yourself is no easy task, especially so when it needs to be done in addition to the usual responsibilities and challenges contractors face including handling clients, hitting deadlines and winning new work. And time can be in notoriously short supply for contractors!

In this blog post we’ll give you the lowdown income tax and national insurance for contractors, some tax tips and how Gorilla Accounting can help.

How does your Business Structure Impact your Tax Obligations as a Contractor?

One of the first decisions you need to make when you decide to start out as a contractor is what your business structure will be, but contractors aren’t always aware of how this affects things from a tax and National Insurance perspective.

The majority of contractors operate through their own limited company with other common business structures being sole traders and umbrella companies, all of which have different tax implications.

Limited Company Contractors

Limited company contractors have control over their remuneration and can pay themselves a small salary at the tax-free personal allowance threshold (£12,570 for the 2023/24 tax year) and supplement their income with dividends. Dividends are taxed at a lower rate than income tax which enables limited company contractors to leverage tax efficiencies and increase their take home pay with the right remuneration structure – this is something we can advise you on!

The limited company must pay corporation tax on the profit it makes and the contractor is responsible for meeting their tax obligations. A limited company structure also offers other benefits such as reduced financial risk thanks to limited liability.

Sole Trader Contractors

When you contract as a sole trader you personally own your business. You have the responsibility of meeting your tax obligations and income tax will be paid on company profits. There isn’t as much scope for Sole Traders to leverage tax efficiencies compared to limited companies, and sole traders are also personally responsible for debts incurred by their business meaning personal assets could be at risk from creditors.

Umbrella Company Contractors

If you contract through an umbrella company, you are effectively an employee of the company and your income tax and National Insurance Contributions are deducted at source through Pay As You Earn.

Income Tax Rates and Bands

The amount of income tax you pay as a contractor depends on the amount of taxable income you earn. The income tax rates and bands are as follows:

  • Personal Allowance – Taxable Income Up to £12,570 – Tax Rate 0%
  • Basic Rate – Taxable Income £12,571 – £50,270 – Tax Rate 20%
  • Higher Rate – Taxable Income £50,271 – £125,140 – Tax Rate 40%
  • Additional Rate – Taxable Income More Than £125,140 – Tax Rate 45%

If you are a limited company contractor, the salary you choose to pay yourself will be taxed as per the above rates. If you contract as a sole trader you’ll pay income tax on your taxable profit once any allowable expenses have been deducted. If you contract through an umbrella company income tax will be deducted through Pay As You Earn.

What About Corporation Tax for Limited Company Contractors?

As a limited company contractor, your taxable profits will be subject to Corporation Tax levied at the main rate of 25% if taxable profits are above £250,000. If taxable profits are between £50,000 and £250,000, you can claim a marginal relief rate which will reduce the amount you pay to between 19% and 24%. If profits are below £50,000, you pay Corporation Tax at 19%.

What National Insurance Contributions Do Contractors Pay?

National Insurance Contributions (NICs) are made by both employers and individuals to pay for a variety of state services and benefits such as the NHS, maternity pay, unemployment benefits, state pensions and more.

As a contractor, you may have National Insurance obligations as an employee and (if applicable) as an employer and it’s important to understand the different types of National Insurance contributions.

Various factors determine the level and type of National Insurance Contribution that is payable, including your age, employment status, how much you earn and your residence status.

Class 1 National Insurance Contributions

Class 1 NICs are paid by employees deducted at source for those that earn more than £242 per week from one job and are below State Pension age.

Class 2 National Insurance Contributions

Class 2 NICs were paid by self-employed people who earned an annual profit of £12,570 or more at a flat rate of £3.45 per week. In the 2023 Autumn Budget Statement, Chancellor Jeremy Hunt announced that Class 2 NICs were being abolished effective from 6th January 2024.

Class 3 National Insurance Contributions

Class 3 NICs are voluntary contributions which can be paid by people to fill gaps in their National Insurance record.

Class 4 National Insurance Contributions

Class 4 NICs are paid by self-employed people who earn an annual profit of £12,570 or more and are currently levied at 9% on profits between £12,570 – £50,270. This will be reduced to 8% effective at the start of the 2024/25 tax year. Class 4 NICs are levied at 2% on profits above £50,270.

Maximising Contractor Tax Allowances and Reliefs

Your Dividend Allowance

Limited company contractors can pay themselves a salary and supplement their income with dividends. Dividends are company profits after tax distributed amongst shareholders of the company. As a limited company contractor, you will usually be the only shareholder.

You get a dividend allowance which means the first £1,000 of any dividends you pay yourself are tax-free. Any dividends above this amount are taxed as follows based in your income tax band:

  • Basic Rate Taxpayers – 8.75%
  • Higher Rate Taxpayers – 33.75%
  • Additional Rate Taxpayers – 39.35%

Dividends are therefore taxed at a lower rate than income tax on salary which presents an opportunity for limited company contractors to leverage tax-efficiencies to reduce their overall tax liability. Our Guide to Paying Yourself covers this in more detail.

Allowable Expenses

Limited company and sole trader contractors can deduct a range of allowable expenses that have been incurred wholly and exclusively for business purposes from their taxable profits resulting in a lower overall tax liability. Examples of allowable expenses include travel, accommodation, mobile phones, computer equipment and business insurance. You can find out more in our Guide to Expenses.

Your Personal Allowance

If your total income is below £12,570, it will be untaxed. If your total income is above this amount, the first £12,570 will be untaxed. This is known as your personal allowance.

How Gorilla Can Help With Your Tax Obligations

The UK tax system is complex and constantly evolving so it can be hard for contractors to keep up-to-date with the changes as well as stay on top of their tax affairs. It’s important to keep detailed and organised financial records covering your income and expenses which must include receipts and invoices. Organisation is key to help ensure your tax liability is calculated accurately.

Deadlines for submitting tax returns and payments must also be met. Any issues with your tax calculations or late payments can result in an HMRC investigation and potential penalties which all contractors rightly want to avoid.

This is where Gorilla Accounting comes in! As a Gorilla client you receive full access to industry standard FreeAgent cloud accounting software. You can use the FreeAgent app to record expenses on the go throughout the year allowing you to stay on top of your record-keeping which helps to avoid a backlog when the tax deadline is approaching.

Invoicing is also run through FreeAgent and powerful automation means your tax returns are calculated in the background while you work. They can then be approved and digitally submitted to HMRC.

This automation is a huge timesaver for contractors and also helps to improve accuracy. With Gorilla, you’ll work with your own dedicated accountant who will be on hand to provide you with unlimited tailored support and advice including how to optimise your tax position and your self-assessment tax return is included as part of our service. You also get a same day response to your queries thanks to our Client Service Guarantee.

If you have any queries about your tax and National Insurance affairs or our contractor accounting service, please call 0330 024 0406 to speak to an accountant or request a callback today.