Limited, umbrella or sole trader...

Which should you choose as a contractor project manager?

A contractor working

This is the number one issue for many project professionals leaving permanent employment for life as a contractor or freelancer. And rightfully so; the choices you make will impact your earnings potential and workload; if you go for the wrong choice, it may end up costing you thousands of pounds.

There are three main choices for how you’ll engage with your clients. You can work as a sole trader, through an umbrella company, or through your own limited company. There are advantages and disadvantages of all three options, so it pays off to do your research in advance, so you’re not pressured into making an uninformed decision.

All numbers and percentages that are quoted in the text are from the tax year 2015/16, unless anything else is mentioned.

Sole Trader

Being a sole trader means that the buck stops with you. You will enter into a contract with your client, provide your services, and be paid as yourself. Below is a broad breakdown of how it works, as well as who it’s normally for.

The set-up: to get started is really quick and easy. Once you have a contract lined up you will have to register as self employed on the HMRC website and then you’re set.

The pay: after each period worked (usually a month) you will have to invoice the client.

Check with your agent what the requirements are, or if your relationship is direct, with the accounting department. Try to send the invoice, along with any timesheet, across promptly after each period. Within the first five business days in the following period is usually fine, but any later than that might prove unpopular. You are also responsible for following up unpaid invoices too if your client is late with the payment.

The tax: your income as a sole trader is taxable as personal income so similar to if you were employed. There are however a few opportunities to make deductions against your tax burden as self-employed, which could bring down your tax you pay. You also need to be aware of that you have to fill out your own tax return at the end of the tax year, so make sure you’re on top of your record keeping.

Payment on account: this point is worth its own entry, and it’s important that you understand what it means and what you have to do. Payment on account are advance payments of the tax you are likely to owe next year. The amount is based on the previous tax year, and is due at the same time as the balancing payment from the previous year. You have to make sure that you set aside enough money to be able to cover this payment.

National Insurance: as self employed you still need to pay National Insurance , but it works a little differently, and you have to make the payments yourself. If your profits are more than £5,965 per year you pay class 2 NI, and if they are over £8,060 class 4 NI.

VAT: if your turnover is over £82,000 you will need register to pay VAT . If this is the case, you will need to increase the prices you charge accordingly to cover this.

The admin: depending on your role and the project you’re working on it may be a requirement to have various insurances in place. At the very minimum, an professional indemnity insurance should be considered, and possibly also a liability insurance. The cost of these are deductible so it doesn’t have to cost the earth, and the peace of mind might well be worth it.

You don’t have to use a professional accountant when you work as a sole trader but you may want to consider investing a little bit of time and money sourcing a professional accounting software suite to help with your number crunching. Some of our clients have recommended Wave Apps as a good free alternative, or for a more powerful set-up Freeagent . These applications allow you to manage all the record keeping as well as invoicing. You can even send out contracts from within the applications themselves, so they could potentially save you a lot of time and hassle.

Who should be a sole trader: anyone who is starting out as independent at a lower level, or someone who will only work part time or part of the year would be well suited to work as a sole trader. Equally, if the profits (before tax) are less than about £25,000, it might make sense to choose this route too. If you earn more than this though, the lower tax burden is likely to be large enough to justify the additional administration of a limited company.

It’s also worth noting that many (if not most) established businesses will only take on contractors who work through a limited company, so make sure you clarify this ahead of taking on your first contract.

Umbrella Service

Using an umbrella service can be a hassle-free option, featuring a minimal amount of admin work and the ability to offset some of the taxes through claiming expenses. It is however the most expensive way of working.

The set-up: working through an umbrella company means that you are employed directly by that organisation through PAYE , and that they act as an intermediary between you and your client, for all pay related matters. Once you’ve secured your contract and have made the decision to use an umbrella company, all you need to do is to choose which company to go with, and contact them directly to set things up.

The pay: you will be paid a salary each month, just as if you were permanently employed. You will typically need to fill out a timesheet in order to be paid, as well as your expenses. The allowable expenses are somewhat limited compared to, say, a limited company, but can in some cases reduce your tax liability somewhat. They include subsistence, travel and accommodation, as well as some general deductions such as training and subscriptions.

The tax: All the tax deductions are already made by the umbrella company and paid directly to HMRC. This means that you won’t be required to submit a self-assessment at the end of the financial year, but you can expect to pay slightly higher taxes than if you would have been a sole trader or ran your own limited company.

The NI: There’s a feature of National Insurance and umbrella services that one should be aware of  – the contractor working through an umbrella solution pays both employee’s NIC as well as employer’s NIC, which needs to be taken into consideration when agreeing the pay rate. This is because of the fact that the umbrella company acts as your employer, and would therefore need to pay employer’s NIC for you, as well as your own NI Contributions .

Other than that, and just like with the tax, the NI contributions will be deducted by the umbrella company directly from your gross earnings, and paid straight to HMRC.

You can expect the NI contributions to be higher than if you were a sole trader, but in return, all the admin is done for you. Currently the class 1 NI contributions that everyone who’s employed needs to pay are 12% of anything between £155 and £815 per week, 2% on everything over £815 and 0% on anything under £155.

The admin: The main advantage with working through an umbrella company is that the administrative workload is minimal. As mentioned, you will need to fill out your timesheet as well as keep on-top of your expenses, on an ongoing basis, but other than that there isn’t much else to do. Most umbrella companies also offer comprehensive indemnity and liability insurances as part of the service too, meaning that you don’t have to worry about that.

Who should work through an umbrella company: Umbrella is generally considered the least tax efficient way of working. However, there are, in our minds, a few scenarios where using an umbrella service would make sense, albeit for a limited time only.

Flexibility: If you’re just starting out as an independent contractor and you don’t know whether it’s for you, an umbrella solution can be a simple and low maintenance way to test the water. You can return to being a permanent employee at any time, without the need for the admin that associated with being a sole trader or running a limited company.

Low income: If you are on a low day rate (say, £120 or less per day), it would probably be advantageous to work through an umbrella for a limited time , as the benefit of any of the other forms of working would be negligible. If you’re able to make use of some of the tax deductions available to you, your net salary would suffer less.

Limited Company

Most serious contract workers conduct all business through a limited company , and depending on your circumstances, this may be the most advantageous option for you too. Additionally, many employers would require you to work through a limited company due to liability, security and administration issues.

The set-up: A limited company is a legal entity through which you provide your services. It is no different to any other privately owned companies, apart from the primary use: to legally minimise the amount of tax paid.

To get started, all you need to do is to set up a limited company , which is simple and straight forward in itself. There are however a number of choices that you need to make, as rectifying them at a later date is likely to be complicated. The set-up will depend on your specific circumstances, so we always advise to consult a specialist accountant before jumping in. Some of the particulars to be aware of are naming, number of shares, company structure, VAT, business banking as well as the full set of responsibilities being a director brings.

The pay: As a company director you are responsible for invoicing the client as well as make sure the invoices are paid, as well as any timesheets and expenses. The payment will be paid into a business bank account that’s been opened specifically for the limited company.

It’s worth mentioning the distinction between a sole trader, who is an individual, and a limited company, which is a legal entity. The income from contracting is therefore not yours in the traditional sense, but belongs to the company. From the company’s income, most contractors pay themselves a low salary every month, in order to take advantage of the tax free allowance (currently £10,600 for the tax year 2015/16), and take any other personal income as dividends.

The tax: Taxation as a limited company owner/director is a little more complex than other forms of employment since there are more variables. If a salary is taken, this is taxed as PAYE , which is straight forward enough. You will then have to pay corporation tax on the profits of the company, currently 20% (under £300,000 profit per annum). There are also other ways of affecting the amount of tax paid, such as hiring a partner or having additional shareholders. We would recommend hiring an accountant to help you get the most out of it.

Dividends: Beside the salary, dividends are another form of extracting funds from your limited company. They are paid out from the company’s taxed income, and are subject to a dividend tax . If you are on an income of £31,785 or less, the part of the dividend that falls in this band will be taxed at 0%. Any dividend payment that falls in the higher rate band, from £31,786–£150,000 is taxable at 25%, and anything from £150,001 at 30.56%.

Note : the tax percentages above are the nominal rates as per the HMRC website, however,  the actual rates are a little higher but are mitigated by universally applied tax credit of 10%. It’s easiest to just use the HMRC figures, and not worry about how they got to them.

The NI: You will be liable to pay both employer’s National Insurance Contributions as well as employee NI Contributions when working through a limited company. Since most contractors pay themselves a relatively small salary on which to pay employee’s NIC, but this is in part made up for by the employer’s NIC, which is payable on the profits of the company.

The admin: It should come as no surprise that this option comes with the largest administrative burden, but the savings in tax should more than make up for it. And if you don’t want the extra work yourself, there are specialist accounting firms out there that include much of the admin in their services.

Invoicing and income control : you will be responsible for the timely issue of invoices, as well as any timesheets, recording of client expenses as well as chasing payments. You can have your accountant do this for you though, and you can also use software to help you manage it better.

Insurance : insurance is mandatory when you work through a limited company, and you should aim to have a professional indemnity insurance as well as a limited liability insurance.

Contracts : just like if you’re a sole trader you’re typically responsible for your own contracts, unless there is an agency involved.  

Accounting and record keeping : contrary to many people’s beliefs, there’s no statutory requirement to have an accountant but they do tend to earn their keep and more. Whether or not you do decide to hire one, you do need to be very conscientious when it comes to record keeping, as missing receipts and forgotten expenses can end up costing you in the long-run.

Who should be working through a limited company: Since there are considerable advantages to working through your own limited company, the answer is that most people who work fixed term contracts should at least consider it. Particularly if they’re looking to be contracting for more than six months and are likely to earn more than £35,000 per annum.

So there you have it - a breakdown of the three options available to you when you leave permanent employment and join the contractor brigade – hopefully it’s been useful.

 Please email us here with your thoughts on the piece; we would love to hear your feedback.

Disclaimer: the information in this piece is, to the best of our knowledge, correct at the time of publishing. However, none of it constitutes professional advice, and we would advise that you always consult a professional if you’re unsure about how to proceed.