Many contractors are confused about whether they would be better off working under an umbrella company or going it alone and setting up as a limited company. The honest answer is that there are pros and cons for both, but what are they and which route would make your business the most profitable?
Contractors working as limited companies
A limited company is a separate legal entity and you are employed by the company. First of all you must form the limited company and open a business banking account to receive and make payments on behalf of the company. The director must decide how much they want to be paid by way of salary or dividends or a mixture. Dividend payments are the most tax efficient way of taking income from the company, because corporation tax payments are taken into account and a dividend tax credit is available meaning those under the 10% threshold would have no dividend tax to pay after corporation tax has been paid. Directors of limited companies can also claim many benefits, reliefs and expenses.
Contractors working under umbrella companies
Contractors who work via an umbrella company are not classed as self employed, but are seen as an employee of the umbrella company and so they pay tax via PAYE. This route is not as tax efficient as a limited company, because you will have to pay the income tax rates set for individuals in the UK and cannot claim the same tax reliefs and benefits as if you are operating via a limited company.
The main advantage of using an umbrella company is that it massively reduces the amount of administration that you need to do while working as a contractor. The umbrella company take the tax and NI contributions off your income before you receive payment in the same way that any employer would, and so the removes the need to save up for tax payments.
Which is best – limited company or umbrella company?
As noted in the sections above, there are pros and cons for each type of business setup. The table below shows the advantages and disadvantages of each to decide which is the best option for you.
Pros of working as a Limited Company
- More tax advantages and ability to reduce tax bill.
- More expenses, reliefs and benefits available.
- Flat rate VAT scheme available.
- You are in control of the finances and no handling is required by an intermediary.
- Running your own business isn't difficult; submit spreadsheets to your accountant - just like umbrella time-sheets and expenses.
- Greater opportunity for tax planning than PAYE Umbrella
Disadvantages of working as a Limited Company
- Larger amounts of administration.
- An expensive way of contracting if you return to employment shortly afterwards.
Pros of working through an Umbrella Company
- A more simplified way of working as a contractor.
- Tax and NI is deducted at source so no HMRC bills.
- Shorter term contracts easier to deal with.
- Great for contractors who have not reached the higher rate tax threshold.
- Good if you are unsure if contracting is for you and you're really just in between permanent jobs.
- Someone else will be doing all the paperwork.
Disadvantages of working through an Umbrella Company
- Not tax efficient.
- Must rely on the umbrella company to obtain payment for work.