As an accountancy firm which provides services for contractors and freelancers, we are often asked all sorts of questions by people who are thinking about contracting for the first time. So we have summarised the options you have for setting up a suitable structure for your business.
Following tax changes in 2007, there are only two real options for contractors:
- Operate through your own limited company.
- Work through a PAYE umbrella company and pay income tax and national insurance contributions on your entire earnings.
Contracting through your own Limited Company
There is a perception for many people that contracting through your own limited company is a daunting task. In fact, nothing could be further from the truth.
Contracting through your own limited company requires just a little work that we help you with. You’ll need to form a company, open a company bank account, send in your paperwork or maintain your accounting system and from time to time send payments to HMRC.
Using an Umbrella Company
An Umbrella service is where you are essentially an employee of the umbrella. Your client or agent enters a contract with the umbrella for your services, and you enter into a contract with the umbrella to provide the service.
Pros and Cons
This is the most tax efficient way of working through a combination of low salaries and high dividends. You can claim a wider range of expenses.
Access to the Flat Rate VAT scheme (If applicable).
You keep complete control of your finances.
It is not as difficult as you may imagine.
You have greater opportunities for tax planning.
Agencies prefer to deal with limited companies, as it removes the costs of employing the contractor.
There is a small amount of admin involved, typically about 15 minutes per month.
May not be ideal if you contract for a very short period of time before going back to permanent employment.
You need to form a limited company, file an annual return and accounts with Companies House each year, file accounts and corporation tax computation with HMRC each year, manage a PAYE scheme, manage a Vat scheme and file a self-assessment tax return each year.
All tax and NI is deducted so you have certainty that you will have no further taxes to pay.
Can be suitable for short term contracts.
Can be suitable for contractors who earn less than £20k per year.
Can be suitable for contractors who are caught within “IR35 “.
Can be ideal if you want to try contracting first before committing yourself.
Very little admin work on your part.
Not the most tax efficient way of working.
You are reliant on a third party to arrange and pay your income.
Financial benefits of contracting through your own Limited Company
- Generally, contractors are paid higher rates due to their skills and flexible nature of the relationship and the fact that many positions can be relatively short-term.
- If you operate through a limited company you have far better tax planning opportunities which can reduce your overall tax burden and increased your take home pay.
- You can offset all your business expenses against your income to further reduce your tax bill.
Outlined below are some of the major benefits enjoyed by contracting through your own Limited Company:
Savings made via National Insurance – With an umbrella company, you will pay both employees and employers National Insurance. Significant savings can be made by operating through a Limited Company by withdrawing your income as a mixture of salary and dividends.
Claiming expenses – HMRC rules state that business expenses can be claimed provided they are “wholly and exclusively” for the purposes of your business. Claiming expenses result in lower profits and a lower corporation tax liability.
The following examples are valid business expenses:
- Meal expenses – If you are working away from your normal place of work or staying away from home overnight you can claim actual costs of meals, as long as you keep your receipts. Note that round sum claims for meals are not permitted.
- Travel expenses – Mileage rates are 45p per mile for the first 10,000 miles in any fiscal year and then 25p per mile thereafter. Also includes public transport costs.
- Accommodation – The costs associated with overnight accommodation can be claimed for.
- Clothing – This is for workwear only and for clothing that you would not use otherwise.
- Training – Provided the training is used in the performance of your duties.
- Salaries – Your own plus any employees you may have.
- Pensions – Company pension scheme contributions are allowable as business expenses.
- Childcare – If your child is cared for by an Ofsted registered child minder / nursery school, a portion of childcare fees can be claimed for as a business expense.
- Home office – The general rule is that you can only reclaim costs that have been ‘wholly and exclusively’ incurred in connection with your trade. HMRC will allow some ‘home office’ claims if they have been calculated on a reasonable basis, and that such claims are not excessive.
- Other expenses – Company formation fees, accountancy and other professional fees, employing staff, bank charges, postage, stationery, telephone calls, mobile phone contract (if the contract is in the name of the company), employer’s N.I. contributions, subscriptions, insurances, business entertainment etc.
Savings made by using the Flat Rate VAT Scheme (FRS) – If your business turnover rises above the Vat registration threshold for the previous 12 months or is due to do so in the next 30 days, your business must register for VAT.
However, if your turnover is less than £150,000 per annum (no minimum), it is possible to gain financial benefits by voluntarily registering for VAT on the FRS; because you charge Vat at the standard rate of 20% but pay HMRC Vat at a lower rate.
Important notes about the FRS:
- If you purchase less than 2% of your Vat inclusive turnover on “goods”, then the FRS may not be suitable.
- If you estimate that your annual turnover excluding VAT will exceed £150,000, you would not be eligible to join the FRS.
- If you are on the FRS and your annual turnover exceeds £230,000 of VAT inclusive revenue you must come off the scheme.
- Companies on the flat rate scheme are unable to claim back any VAT on expenses for their business unless it is for capital assets purchased for over £2,000.
- You are still required to complete a quarterly VAT return.
- The FRS is designed to simplify the VAT system and when used, gives many businesses the ability to earn money from VAT.
Paying yourself – Salary/Dividends
Salary – The amount you pay yourself through the company as a salary will depend on your personal circumstances but in the majority of cases will be at a level to utilise your personal income tax allowance without incurring further tax or national insurance.
A salary equivalent to the earnings limit (EL) is the amount you can earn without paying tax or national insurance costs; and you still receive national insurance credits towards your state pension and other benefits.
To pay yourself a salary the company would need to register as an employer and run a payroll.
Dividends – You can declare and pay yourself a dividend when you want. Generally, they are paid quarterly or half yearly but they can be paid as often as you want.
Dividends can only be paid out of after-tax profits. If your bookkeeping is up to date you should be able to determine the dividends available to you.
If funds are taken from the company that are neither salaries or dividends then the company is lending money to you as the director. Holding a director’s loan account can have tax implications and should be carefully monitored.
When declaring a dividend, board minutes and a dividend voucher must also be prepared.
Intermediaries Legislation (IR35)
IR35 tax legislation was announced in 1999 and took effect from April 2000.
What is it and why did the government introduce IR35? – The legislation was designed to tax those in “disguised employment” at the same rate than if they were employed. This resulted in contractors caught by IR35 paying more tax than a traditional limited company arrangement; up to 25% more in some cases.
IR35 legislation was used to tackle tax avoidance schemes through the use of intermediaries, such as Personal Services Companies (PSC).
The view of HMRC was that a large number of contractors in various industries were often treated as self-employed when in fact they should have been treated as employees of the end client.
Will I be affected by IR35?
Not necessarily, however, all contractors need to be aware of IR35, its implications and know how to act to protect themselves from it.
IR35 is a complicated area of tax law and determining whether or not you are caught by IR35 is not always straightforward; there are many factors that must be considered. It may depend on the terms and conditions of the contract between the contractor and the client, together with the contractor’s actual working arrangements.
If your contract is “caught by IR35”, then all income is considered “deemed salary.” Income tax and national insurance would need to be deducted after allowing for business expenses. The financial effect for a contractor working inside or outside IR35 may result in a difference of 20% in net earnings. Only the following expenses can be claimed;
- 5% administration allowance (this is not available for public sector contractors).
- pension contributions.
- certain professional subscriptions.
Limited company formation – If you are forming a new limited company you will need to decide on its name, check whether the name is available and register it with Companies House. You would then be required to register your business with HMRC for corporation tax, PAYE, Vat and your personal self-assessment tax returns.
Business bank account – If you operate a limited company then you must keep a separate business bank account for the company. It is advisable to keep your business and personal expenditure separate and use the business bank account for business transactions only.
Bookkeeping – It is best to maintain the bookkeeping on a regular basis, ideally monthly. Remember that receipts need to be kept for all expenses and be filed systematically (we recommend keeping a monthly system for filing, so transactions can be traced easily if required). It is a legal requirement that all business records (bank statements, receipts etc.) must be kept for six years plus the current accounting year.
Corporation Tax – calculated on the profits of the company and is set at 20% of profits. It is advisable to set aside this amount in a separate savings account in preparation for when it is required. Corporation tax is due 9 months after the company year end.
Personal Tax – As a company director you are required to submit a self-assessment tax return every year. Your overall personal income will consist of a combination of salaries, dividends plus any other forms of income (i.e. rent, interest, other dividends); you may need to budget for income tax.
- Confirmation Statement – to Companies House with a fee of £13 (included in your monthly fees).
- Annual Accounts – to Companies House and HMRC.
- CT600 corporation tax return – to HMRC.
The late filing of any of the above reports or late payment of taxes will result in penalties.
National Minimum wage – There is no requirement for a company director to be paid the national minimum wage.
We hope this article has helped to simplify some of the issues involved in contracting. However, if you have any further queries or wish to discuss setting up your own limited company, please do not hesitate to call us.
We pride ourselves on giving our clients the highest level of service.
- We can meet with you to explain how best to manage your limited company.
- Explain which expenses you can claim for through your limited company.
- Explain how you will be financially affected.
- Advise on and help set up your accounting system.
- Answer any questions you may have.