Choosing to be Either an Umbrella or Limited Company Contractor?
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Working out the best structure for your business is a conundrum many contractors face. While going down the sole trader route remains a popular option for most, others choose to set themselves up as a limited company or contract via an umbrella company but working out which is the best route (a limited vs umbrella company) can be tricky. Indeed, of the 5.8 million small businesses in the UK, as estimated by the National Federation of Self Employed & Small Businesses, over half are sole traders (3.5 million) and 2 million are limited companies.
Deciding which approach to take may be determined by the industry you work in or the financial set up that works best for you. For some contractors, they would only be able to pitch for certain work by operating through an umbrella company. Meanwhile limited companies, or personal service companies, benefit from greater tax efficiencies and financial protection.
Before considering which company structure may work best for you, here is a basic definition of what both do:
Limited company explained
If you set up your own limited company, you become its director and are fully responsible for everything your company does. As director, you are in control of the clients you take on and the transactions your company makes, which means it’s up to you to ensure you comply with all contractor-specific legislation such as IR35, and handle all tax payments, payroll calculations and returns. The upside is that this is the most tax efficient business structure – you pay yourself in the form of a basic low salary and draw the remainder of your earnings in the form of dividends, which are not subject to National Insurance Contributions.
Umbrella company explained
Contracting via an umbrella company doesn’t have the same level of responsibility. You can still choose what work you take on and how you operate, but, in essence, the umbrella company treats you as an employee. You sign up with them and they pay you when you’ve completed work for the client. The benefit here is that they handle all tax deductions and take on most of the administrative burden. It’s an appealing route for contractors that are just starting out.
Weighing up the pros and cons
Here are some of the main differences between contracting via a limited company and umbrella company, including the pros and cons, to help you choose the most appropriate set up for you.
Responsibilities and admin
Limited company: Directors have several statutory and financial duties. They can set up the company within a few hours, usually with help from a specialist contracting accountant who will guide them through the process. Registration for taxes (VAT and Corporation Tax) will take up to a few weeks. Directors will need to carry out regular admin duties to ensure their accounts are up to date. They will also handle all client invoicing.
Umbrella company: Contractors with umbrella companies have no legal duties and can get set up instantly with a contractor specialist. The administrative burden is minimal. Contractors submit their timesheet and the umbrella company invoices on their behalf and handles all tax deductions.
Tax and IR35
Limited company: As already mentioned, this is the most tax efficient way to contract. That’s because most directors choose to take a low salary (up to the maximum personal tax allowance) and pay themselves the rest of their earnings in dividends, which are exempt from National Insurance deductions. They can also plan their tax payments in a highly flexible way, timing dividends to maximise the use of lower tax bands. However, new off payroll tax rules called IR35 threaten limited company contractors with higher tax rates if they fail an IR35 test, meaning they lose most, but not all, tax benefits of being limited.
Umbrella company: Because you’re treated as an employee of the umbrella company, your entire salary is taxed via the PAYE system, meaning all tax and National Insurance Contributions are automatically deducted. This set up is less tax efficient than working via a limited company and means very few tax planning opportunities are available to you, but it also removes any financial and administrative burden. An added bonus is that IR35 is irrelevant as you’ve already been taxed.
Control
Limited company: You are the director of your own company and this means you have a high degree of control over your business. Decisions over who you work with, what clients you take on and how you handle your accounts are totally up to you.
Umbrella company: As you are in effect an employee of the umbrella company, you have little control, but you can still choose what work you take on. At the same time, you benefit from avoiding the hassle of running your own business.
As you can see here, there are pros and cons to both business structures and while some individuals are swayed by the tax efficiencies they can gain from setting up their own limited company, others prefer the flexibility and freedom that comes with working for themselves yet having an umbrella company do the administration for them.
If you want to learn more about contracting and need help navigating IR35, please contact our team of tax specialists for no-obligation advice. You can also head to our Knowledge Hub for the latest industry insights.
