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 legal structure you choose affects how much tax you’ll pay, your management structure, and what records you’ll need to keep. As with most start-up business, you essentially have three main options:
Operate as a sole trader
Set up a limited company
Create a partnership (you’ll need a friend!)
Setting up your contracting business as a sole trader
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.
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 UK tax rates, thresholds, and allowances explains how much NI self-employed people pay, depending on earnings.
What are the benefits of being a sole trader for contractors?
Are there any disadvantages to being a sole trader for a contractor?
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.
Operating as a contractor with a limited company
Limited companies are completely separate legal entities from their owners and directors. You’re not legally responsible for the company’s debts or liabilities, but this also means any profits belong to the company.
In order to begin trading you will need to register as a limited company with Companies House. This is called incorporation – a process which the video below explains in more detail. A limited company needs at least one director to start up, and must submit annual accounts to Companies House.
The benefits of running your contracting business as a limited company
The beauty of setting up as a limited company is limited liability. It’s more costly and admin-heavy to register, but if anything goes wrong, only assets belonging to the business can be seized – not the personal assets of directors or shareholders.
It’s often more tax-efficient too. Many company owners are both directors and shareholders, essentially taking a salary as an employee of the business, and then receiving dividends alongside it. Read our article about the most tax efficient salary for company directors.
Key point: National Insurance and limited companies
Depending on the salary that you take, you might need to pay Class 1 NI as an employee, whilst the company pays Class 1 NI as an employer!
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, and is likely to be easier to sell up.
What are the practicalities of running a company?
As company director it’s your responsibility to make sure that the company submits the correct tax returns and accounts to HMRC and Companies House each year. As an individual who is a company director, you’ll also need to complete a Self Assessment tax return.
If you don’t normally fill in a tax return, you’ll need to sign up for Self Assessment on the Gov.uk website. Each time you submit your tax return, you’ll need to provide details of the income you receive as a director, as well as any other income you receive.
3. Setting up a partnership
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 for Self Assessment.
Partnerships have no legal status in the way that limited companies have. 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 gains are generally shared between each of the partners, unless a different agreement is set up that says otherwise.
Are there any disadvantages of 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 – it doesn’t matter, 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.
What about limited liability partnerships?
You may decide to set up a limited liability partnership (LLP). This offers partners the benefits of limited liability, whilst allowing them the flexibility of organising their internal structure like a normal partnership.
LLPs are separate legal entitles, 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 as an LLP, though usually it’s only used by firms of professionals, like solicitors.
Whichever set up you choose, make sure you get it right first time
It can be a big (expensive) headache to change your business structure once you’ve begun trading. This is why it’s well worth speaking to both a solicitor and an accountant beforehand, so you can feel confident you’re on the right path.
Getting your head around the various legal and tax implications of being a contractor can be a challenge. Chat to one of the team at The Accountancy Partnership to discuss your options, or learn more about our online accounting services. Call 020 3355 4047, or grab an instant quote online.
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About The Author
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.