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When you set up in business as a contractor you might either work as a sole trader or as a limited company. There are pros and cons to either business structure, depending on your circumstances and preferences.

For instance, working as a sole trader means less administration, but this structure also offers less personal protection. There’s no legal separation between you and the business, so any debts will affect you personally.

On the other hand, a limited company has more protection, but it also has more administrative demands. There is a third option that can be very attractive for contractors; an umbrella company.

There are different rules and regulations depending on which structure you choose as a contractor business, which can also affect how much tax you pay. In this article we’ll take a look at the different ways contractors can work, so you can decide which structure suits you best.

The pros and cons of contracting as a sole trader

Working as a sole trader is arguably the easiest way to work as a contractor. You simply turn up for work, keep your normal business records, and make a Self Assessment submission when it’s time.

Any profits are yours to keep because there’s no legal separation between you and the business. The downside is that this means you’ll pay tax on those profits even if you don’t actually ‘withdraw’ them from the business.

The fact that the business is you is also an important consideration in terms of personal liability. If something goes wrong and the business gets sued or owes money, then it’s you who is sued or in debt!

You may need accounting support (or you can deal with taxes yourself) but in general, being a sole trader contractor is a relatively simple and straightforward existence. Sole traders can also employ people in the same way as a limited company does, and you can invest money and work for multiple clients.

Limited companies for contractors

One of the popular myths of starting a limited company is that you need other people to run it, but this isn’t actually the case. Plenty of limited companies are run by a single owner who is also the sole director.
 

 
As the only shareholder, you are in total charge. You manage the pay, and you decide on what the company does and how it does it. Whether or not you think this responsibility is a positive or negative might depend on you!

Operating your contracting business as a company does have the advantage of offering limited liability. The business is a separate legal entity to you as its owner, so if the company runs into problems, then your personal assets are largely safe.

The extra admin involved with contracting as a limited company can put some people off. As well as submitting a Company Tax Return, the business must send annual confirmation statements, and you as the director will need to make Self Assessment submissions. It can be time consuming!

Umbrella companies for contractors

Another way for contractors to work is through an umbrella company. This is where a contractor works for clients through a third-party company which employs them as a temporary worker, rather than working through their own company.

The umbrella company doesn’t find and supply the work in the way that a temp agency might. Instead, they exist to offer contractors a medium to work through.

Umbrella companies can provide this service to many contractors, and because they take care of all the reporting requirements, they can be a popular option. The idea is that the umbrella company provides the contractor with the protection and tax efficiency of a limited company whilst offering the relative simplicity of employment.

Contracting through an umbrella company also means you’ll receive payslips from a business that you aren’t a director of. It can be helpful if you are applying for a mortgage!

 

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How do umbrella companies pay contractors?

You (as the contractor) and your client will normally both need to sign a contract with the umbrella company. You’ll then submit regular timesheets or statements of work to the umbrella, so they can raise your invoices with the end client.

The umbrella company invoices the end client separately, and pays you (the contractor) through its payroll. This takes care of all of the statutory reporting and payments, such as PAYE, just like any other employer.

What protection does an umbrella company offer?

Because you’re working through a third-party limited company, there’s a higher level of personal protection, especially compared to operating as a sole trader. Although the protection is in place, an umbrella company may ask you to sign agreements in case of professional negligence.

Are umbrella companies expensive?

Now naturally, working through an umbrella company comes at a cost. It varies, but the umbrella may charge you:

  • A monthly fee
  • Fees for particular services, such as income statements
  • A percentage of your turnover
  • A mixture of all of these

You might need to consider which is worth more to you; the convenience of not having to manage your own limited company, or the cost-efficiency of working through an umbrella.

There’s no denying that an umbrella company can be very useful for a contractor, especially if you only plan to work this way for a short period and won’t need your own limited company afterwards.

How IR35 affects the way you carry out contracting work

IR35 rules are a section of legislation dealing with the way that contractors work. A contract is ‘inside IR35’ if the contractor is essentially working as an employee, but doing so through their own intermediary, such as a limited company.

We explain it in more detail in our IR35 article but in short being within IR35 means:

  • The ‘employer’ doesn’t have to pay the extra expense of making employer NI contributions
  • The contractor can pay themselves through their company using a combination of salary and dividends, which is more tax efficient than working as an employee
IR35 sets out to close these tax loopholes.

 
If a contract is ‘within IR35’, then the entity which pays the contractor will deduct income tax and NI from their payments. So, choosing the most tax efficient way of working also depends on whether the contracts you take are inside or outside IR35.

  • Inside IR35: Contracts are likely better being with an umbrella company
  • Outside IR35: Contracts are normally more tax efficient via a limited company

How do you choose an umbrella company?

There’s one important point we need to make right at the start of this section, and it is if it sounds too good to be true then it probably is!

Don’t be swayed by umbrella companies that claim to save you ridiculous amounts of money through ‘innovative’ tax schemes. HMRC is very hot on tax avoidance and evasion.

There are plenty of examples of umbrella companies using aggressive avoidance techniques, leaving contractors (you) with big tax bills, interest, and nasty penalties.

Instead, look for umbrella companies that have a good name in the sector and who have excellent reviews. Find companies that seem to be even-handed in their promotion of the scheme rather than businesses making outlandish promises.

A mix of convenience and efficiency

Umbrella companies are very useful for contractors who just want to get on with their job and don’t want the hassle of running their own company.

That said, running your own limited company can help you stay in control of your business, and there are options to outsource your accounts and admin. A good accountant can even help you register the company!

 
Learn more about our online accounting services for businesses. Talk to the team on 020 3355 4047 or get an instant online quote.

About The Author

Rachael Anderson

A creative content writer specialising across business, finance and software topics. I have a love for all things writing, and creating engaging, easy to understand content that helps everyday people! Learn more about Rachael.

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