IT Contractors - Limited or Umbrella Company?

If you’re about to cast off from the shores of the permanently employed into the potentially stormy but nonetheless lucrative waters of IT contracting or freelancing then stop for a moment and consider before launching yourself into the deep.

In particular, you need to set up your new business in the best way so that you minimise your long term tax liabilities, while maximising your income and making it easy for your customers to deal with you.

This is a hot topic and one that is close to the hearts of many first timers. For example, on the UK’s largest website for IT contractors, Contractor UK, a recent post on their bulletin board had over 3,500 views, demonstrating the potential confusion in the IT sector.

In essence, your choice is between setting up a limited company or operating under what is called an umbrella service company, of which more in a moment.

Setting up and running a limited company, where you become a director and shareholder, is the most tax efficient way of working and has a number of advantages.

For example, you can claim back a wider range of expenses, including accountancy fees, equipment and software costs; you can also access a VAT scheme known as the flat rate scheme, which allows you keep some of the VAT you receive, for example, with a contract worth £100,000 you would make an extra £3,400 in your first year of trading. Perhaps as importantly, you have complete control over your financial affairs.

Contrary to general belief, running your own company is not extremely difficult and, with the assistance of a good accountant, is no more challenging than any other form of trading.

Despite this, there are contractors who still prefer not to get involved in any paperwork, beyond producing weekly or monthly timesheets. Other only intend to contract for short periods between longer phases of permanent employment.

The alternative for these people is to use the services of an umbrella company, where they enter into a contract with the umbrella company and effectively becoming PAYE employees again, with the company then contracting with their customers and taking responsibility for invoicing, paperwork, collection of money due and payments to each contractor, less tax and National Insurance deductions.

Although this system is generally fairly simple to use it offers little benefit for individual contractors in terms of reducing tax liabilities, and may actually increase their costs as service fees levied by umbrella companies may reach as much as 9% of the value of the contract. It is also worth noting that many umbrella companies insist on either a minimum level of charging or a minimum time for which you must pay for their services. By comparison, accountancy fees for running a limited company are around £1,000 per year, irrespective of turnover.

If you are planning to use an umbrella company then you need to ask three key questions: What exactly will they charge; is there a minimum charge; and what tax or accountancy qualifications does their form possess?

Finally, there is a third option called a composite company, where a number of contractors use the same company through which to bill their services. Although composite companies can simplify many of the paperwork processes they have complex and artificial share structures that are the target of investigations by the Inland Revenue.

In terms of your ability to maximise your income, forming a limited company is the most attractive option, allowing you typically to take home over 80% of what you earn; this compares favourably with umbrella services and composite companies where you will expect to take home approximately 65% and 73% of your earnings respectively.

One final point to remember is that, whatever you may hear to the contrary, you can only claim expenses for items that you have actually purchased; this is true regardless of the type of company structure used. Note that many umbrella companies refer to ‘special dispensations’ in their marketing materials, implying that you can claim more expenses by using their services. Any good accountant will, however, tell you that these claims are nonsense and that expenses are either allowed or disallowed by reference to Tax Law and not by reference to the company that you use to calculate your payroll.

Ultimately, the choice of company will be determined by the needs of each individual. Before making a decision, however, it’s important that you consult suppliers and accountants who specialise in the sector.

This will ensure you have a fuller understanding of the options, are confident that the person with whom you will be working is fully qualified to manage your tax affairs and, as importantly, that you are aware of the exact costs involved.

Our thanks to Simon Dolan at www.sidaccountancy.com