Becoming a Contractor: Limited Company vs an Umbrella

From a better work-life balance to a higher rate of pay, the benefits of becoming a contractor are vast. Early on in your contracting career you'll want to work out the best trading arrangement for you. There are two main options, and your choice will usually depend on the detail of your contract and whether you see yourself contracting in the long term.

Trading through your own limited company:

As the director of your own limited company you’ll have access to legitimate tax planning opportunities that are not available to employees, so you’ll usually get to keep more of your contracting income. The agreed contract rate is paid to your limited company and you then have a great deal of flexibility in how your company pays you. This will usually involve a small salary combined with a dividend, but a specialist contractor accountant will advise you how best to proceed.

It’s more work than the alternative and it has fixed costs attached, so it’s generally more beneficial for higher earners and we’d only recommend it if you see contracting as a long-term career. It’s quite common for new contractors to start with umbrella employment and switch to their own limited company once they’re established and certain that the contracting life is for them.

You will need to make provision for your own time off, including holiday and sick pay, as your company will only be paid when you work. However, many contractors find that the difference in their income makes up for the need to make their own arrangements.

Umbrella employment:

As the name suggests, the other option is to be employed by an umbrella company. The strength of umbrella is that it allows you to combine the freedom and flexibility of contracting with the security and stability of employment. Umbrella companies are often regarded as a ‘halfway house’ between employment and contracting. Compliant umbrellas often present the worker the flexibility and freedom they get while contracting and working at different workplaces on a temporary basis.

The agreed contract rate will be paid to the umbrella company who will cover their costs and pay the remaining amount to you through PAYE, making all necessary deductions for income tax and national insurance before paying you. This means that the amount paid to you is your net pay, and you won’t need to complete a tax return unless you have income from other sources.

From the contractor’s point of view, umbrella employment is extremely easy. You just submit a timesheet and maybe an expense claim each week and the umbrella company takes care of the rest. The umbrella company is your employer so you have the rights, protections and benefits afforded to all UK employees, including sick pay, maternity/paternity pay, access to a workplace pension and holiday pay.

Which option should you choose?

Your choice of working arrangement will depend on lots of different factors, many of them personal to you. For example, how comfortable are you with the responsibility of being a company director? Would you rather have less administration to do or have complete control of your career and finances? Is it more important that you’re tax efficient, or that you know you’ll be paid when you’re ill? For this reason, we advise you to talk your personal situation over with an expert so you can come to an informed decision based on the factors that matter most to you. 

Tax responsibilities and IR35 Compliance

The off-payroll IR35 reforms may make you consider your future as a contractor versus an umbrella employee. The reforms shift the responsibility of assessing the employment status of a contractor to the end-client and most importantly, the underlying tax liability too. We usually recommend trading through a limited company to those who see contracting as a long-term career choice, command higher contract rates and consistently work outside IR35. This means that you’re genuinely in business for yourself providing services for your client, rather than working as a “disguised employee”. As of April 2021, changes to IR35 mean that contractors who are medium or large companies conducting business with intermediaries will be obliged to conduct a status determination statement, also known as an ''SDS'. This means that contractors in the private sector can no longer independently set the IR35 status of their own assignment. The contractor, client and any intermediary parties involved, are all responsible for remaining IR35 compliant. If the contract is amended, the client must create a new SDS, assessing whether changes have altered the IR35 status of the relationship with the contractor. However, in September 2022 Chancellor Kwasi Kwarteng announced that the UK government will scrap the 2017 and 2021 reforms to the IR35 off-payroll working rules, described as "a huge victory for contractors" by Seb Maley, CEO of IR35 specialist consultancy firm Qdos (AccountancyAge, 2022). Until these reforms are made, the current format under IR35 remains in place for the foreseeable future.

IR35 can be daunting and off-putting if you are unsure if you want to be a contractor. A survey conducted three weeks in advance of the reform launch date found that more than one-third of medium-sized businesses affected were worried about their readiness for changes (Contractor UK). Trading through your own limited company can be extremely rewarding, both financially and in terms of autonomy, flexibility and work/life balance, but it also comes with considerable responsibilities and represents a commitment that many first-time contractors are often not willing to make. However, being a contractor can still offer a better financial return than being an umbrella employee. Add to that the other non-financial benefits, such as the freedom to choose your work and flexibility to achieve a suitable work/life balance, contracting will remain an attractive option for many people, despite IR35’s best efforts.

Umbrella employment is usually a better choice if you’re not sure you’ll be contracting in the long term, or if you don’t want the responsibility of being a company director. Those on lower contract rates or working inside IR35 may find that they’re better off with umbrella, as they are likely to be tax inefficient otherwise. Being employed, and having one employer for all your contracts, can be very convenient and is a more comfortable situation for many new contractors. It’s quite common for umbrella to be used as a “gateway” to contracting, as you can always “go limited” at a later date. But equally, many say ‘brolly working’ can make life simpler, with less paperwork, and less worry (about IR35 among other things).

It's important for you to closely consider the factors determining your decision, such as the benefits, responsibilities, outcomes, and repercussions between limited companies and umbrella employment, as well as your personal values and appetite for risk before you choose your next career move. 

Written by our umbrella partner, Orange Genie.

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Elle Butler

26th September

Career Advice Industry Insight