Setting out to become a self-employed contractor will often mean you need to decide what sort of business structure you want to use, but working through an umbrella company is another popular option.

The way you structure your contracting business will affect how you report and pay tax, so it’s a big decision. In this article we explain how umbrella companies work, and what this means for your tax reporting. You can also find more guides and templates for contractors in our resource centre.

What is an umbrella company for contractors?

This is where a contractor works for their clients through a third-party company which employs them as a temporary worker, handling their payroll, tax, and admin – rather than contracting through their own company. The umbrella company doesn’t find and supply the work in the way that a temp agency might; 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.

How umbrella companies work

The umbrella company is basically an intermediary between you, your client, and HMRC, and acts a bit like your employer for payroll purposes. Your client will pay the umbrella directly, which will then pay you for the work you do minus any taxes and their fees.

• Secure a contract with a client, and register it with an umbrella company
• Submit timesheets to the umbrella
• They’ll make any deductions through PAYE (such as income tax, National Insurance, or Student Loans) just like a regular employer, along with their fee
• The umbrella invoices the client

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.

Do I still need to submit a tax return if I work through an umbrella company?

If the only contracts you carry out are all going through an umbrella company then they’ll handle your tax reporting through payroll, so you won’t need to register and send tax returns separately. If you’re already signed up for tax returns though, make sure you either deregister or send a return as normal depending on what your long term plans are! You don’t want a penalty from HMRC because you didn’t send a return when they were expecting one.

What protection does an umbrella company offer?

Working through a third-party limited company does mean there’s a higher level of personal protection, especially compared to contracting as a sole trader. That said, most umbrellas will ask you to sign agreements in case of professional negligence.

Are umbrella companies expensive?

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

 
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 with 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.