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Independent contractors, consultants, or freelancers are self-employed individuals who work for businesses, usually on a short-term basis. Hiring a contractor enables firms to access specialist skills, knowledge, and experience, without actually taking someone on full time. This is often very appealing.

If you’re thinking of becoming a contractor, you’ll need to decide what kind of legal set up your business will have. It’s known as your “legal structure”.

The term ‘contractor’ doesn’t actually refer to the legal structure you use when you register your new business, so you’ll need to decide which option works best for you.

This is particularly important for contractors because your business’s legal structure can have an impact on IR35 rules, the amount of tax you pay, and the records you need to keep. Like most businesses, contractors have three main options when deciding how to register:

  • Operate as a sole trader
  • Set up a limited company
  • Create a partnership (you’ll need a friend!)
Read our guide to starting a business.

Becoming a sole trader is usually the simplest route into contracting in terms of admin and tax. You don’t need to register with Companies House, so won’t have to file annual accounts with them, and there’s very little admin to get started.

As a sole trader you and your business are, legally speaking, the same thing. There is no distinction between yourself and your business, so you get to keep all the profits after tax. On the flip side of this, any business debts or liabilities are also your responsibility. If your contracting business runs into trouble, all the financial and legal responsibility falls to you to sort out.

This might be something to consider, especially if your business will regularly buy a lot of materials or resources on credit, and then pay the bill at a later date. For instance, a builder who buys construction materials, and pays the remaining balance of the bill once they’ve sold the property.

Paying tax as a sole trader contractor

Contractors who operate on a sole trader basis must register for Self Assessment so they can report their earnings.

It’s important to keep accurate records of your business income and expenditure because this will help make sure you enter the correct information on your Self Assessment tax return, pay the right amount of tax (and claim tax relief on any expenses!)

Keep in mind that you might also need to pay fixed-rate Class 2 National Insurance contributions (NICs), as well as Class 4 National Insurance contributions on any profit you do make. Our article about paying tax when you’re self-employed explains how it works in more detail.

What are the benefits of being a sole trader contractor?

Plenty of contractors prefer being a sole trader because it’s easy to start up, and offers more flexibility. You’ll need to record all of your transactions (a process known as bookkeeping), and submit your Self Assessment tax return on time (and pay the bill!).
 

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Are there any disadvantages to contracting as a sole trader?

You are totally responsible for your business, so if there are any debts or other liabilities it’s you that pays them out of your own pocket. This could mean your home or other personal assets are at risk if you don’t have the cash available.

You might also find that some contracting agencies won’t work with sole traders, which can have a massive impact on your ability to find work.

Limited companies are completely separate legal entities from their owners and directors, so you won’t be liable for the company’s debts, but this also means any profits belong to the company.

You’ll need to register the business with Companies House (a process known as incorporation) so that you can begin trading.

 

The benefits of running your contracting business as a limited company

The beauty of setting up as a limited company is limited liability. The company is a separate legal entity to you as the owner, so although the process can be a little more time consuming, your personal assets are safe it the company can’t pay its bills.

It can sometimes be more tax-efficient too. Many small companies are run by people who are both directors and shareholders, enabling them to pay themselves a combination of a director’s salary and dividends.

Another benefit for contractors in particular, is that starting a limited company rather than operating as a sole trader can help your business appear more credible. Many contracting agencies won’t work with sole traders, so running your business as a company can help you source more work. It can also be much easier to raise finance or sell the business.

What should contractors know about running a company?

As a company director it’s your responsibility to make sure that the company submits a Company Tax Return and accounts, and pays its bills on time. Because the company is separate to you as an individual you’ll also need to submit a Self Assessment tax return to report and pay tax on any money you take out of the business for yourself. If you don’t normally fill one in, then you can sign up for Self Assessment on the Gov.uk website. You’ll need to provide details of the income you receive as a director, as well as any other income you might get.

Another consideration for contractors running a limited company is IR35. The rules were introduced to minimise the risk of people avoiding tax by setting up a limited company and working for a client through that, when they would otherwise be considered the client’s employee if the company didn’t exist. IR35 can be very complicated to get to grips with, so always ask for help if you’re not sure!

Learn more about what IR35 means for contractors in our article.

Setting up a partnership allows contractors to share the responsibilities, costs, and risks of running a business with other people. It’s a simple and flexible way for two or more people to own and run a business together.

You don’t need to register with Companies House, reducing some of the administrative burden. Instead, each partner is self-employed in their own right, and then registers the partnership as an entity for Self Assessment.

Partnerships have no legal status in the way that limited companies have, so they simply act as a way of linking two or more self-employed people together, though partners can also be a limited company, or another partnership!

The profits and losses are generally shared between the partners equally, unless they make a different agreement saying otherwise.

Are there any disadvantages to setting up as a partnership?

If you go into partnership with someone, you must be absolutely sure you can trust them. Even then – make sure you have an agreement in place before starting up! This is because all debts and liabilities are the responsibility of each partner personally. Creditors can seize personal assets if the partnership runs into difficulties – even if your partner ran up the debt and you didn’t. You’re still liable.

Partnerships don’t (usually) file public accounts with Companies House so, like sole traders, partnerships can represent a bit of an unknown quantity. Other firms may be wary of doing business with you.

You might also find winding up your partnership to be a drawn out (and therefore expensive) process. It’s another reason why a comprehensive Partnership Agreement, covering all aspects of the partnership, is essential.

In some respects a Limited Liability Partnership (LLP) is sort of between a limited company and a general partnership. It offers partners the benefits of limited liability like a company does, whilst also allowing them the flexibility to organise their internal structure like a normal partnership.

LLPs are separate legal entitles to the people who own and run them, so the business will be liable for its own assets, debts and liabilities should things go wrong. The liability to each partner is limited to the amount they invested into the business.

In principle, two or more partners in any business can set up a Limited Liability Partnership (LLP), though they’re most commonly used by professional services firms, like solicitors.

Learn more about our online accounting services for businesses. Call 020 3355 4047 to chat to the team, and get an instant online quote.

About The Author

Dean Salmon

I'm an AAT and ACA qualified Chartered Accountant with over 13 years experience working with businesses, contractors and sole traders. I also love watching live music, and quizzes! Learn more about Dean.

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