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Contractors usually either operate through their own limited company, or through an umbrella company.

An umbrella company is a standard UK limited company, operated by a third-party supplier, which contracts with employment agencies or clients on behalf of contractors.

The umbrella company invoices the client for the contractor’s work, so the client is paying a company and has no need to operate PAYE or pay employer’s National Insurance on top of the invoice amount.

The contractor is an employee of the umbrella company, and is paid a salary under PAYE by the umbrella company. The advantage for the contractor is that they are saved the administration of running their own company.

Before 6 April 2016, there was a tax advantage for the contractor in that their travel expenses to and from work would often be tax deductible, as each place of work was treated as a ‘temporary workplace’ for tax purposes. However, this is no longer the case where the contractor is subject to the supervision, direction or control of the end client. The amount the contractor receives through the umbrella company is pretty much the same as they would receive were they paid as an employee, with PAYE deducted by the client.

Limited Company

A contractor can set up their own limited company and become a company director. Directors are responsible for ensuring the company submits accounts to Companies House and meets HMRC deadlines, however most of the work can be taken on by an accountant; software such as FreeAgent means that the administration involved in running a company is not particularly onerous these days.

Operating through a company is generally the most tax efficient way to be paid. Corporation tax rates are significantly lower than income tax for higher rate taxpayers. Company owners have flexibility over how and when to withdraw profits and are able to take advantage of the dividend nil rate band, the savings nil rate band, National Insurance thresholds, and also to save tax as a family through transferring shares to their spouse.

IR35

IR35 refers to a set of rules which prevent individuals from avoiding tax by routing their income through a company and paying themselves dividends in situations where, if the individual’s services were supplied directly rather than through a company, they would be an employee and paid through PAYE, with the associated National Insurance costs.

Where these circumstances exist, the company is deemed to make a payment to the worker, and PAYE and National Insurance are deducted from the deemed payment. The tax benefits of contracting through a limited company are thereby pretty much wiped out, and if all contracts come under the IR35 rules, it may be preferable to work under an umbrella company for administrative simplicity.

Public authorities engaging contractors through limited companies have an obligation to assess whether IR35 applies to the contract, and if so, to deduct PAYE and NI from payments made, and also to pay Employer’s NI on the amount.

Self Employed

There is no particular reason why a contractor cannot simply be self-employed, and not operate through a company at all. Traditionally client have preferred to pay a company rather than an individual, as that guaranteed that there could be no potential issues for the client if HMRC later questioned the contractor’s employment status. This all appears to be changing, with public sector contracts carried out through companies now also subject to PAYE.

The self-employed are those who are in business for themselves, reaping the rewards – or running the risk – of the success or failure of their business. The test of self-employment is used to determine whether IR35 applies to workers engaged through their own company.

Please see the separate guide for more information about self-employment and how the self-employed are taxed.