Many of the contractors who contact us don’t really know why they are in an umbrella company or that they could be paying thousands in tax and national insurance contributions that they need not be.  This article explains the differences between limited companies and umbrella companies.

The big picture

Limited company

A limited company is owned by its shareholders (you) and is legally a separate legal “person” distinct from its shareholders and directors (also you) which can be a bit confusing.  There is a body of law that governs companies (the Companies Act) and imposes certain obligations on them e.g. to prepare accounts for its shareholders and to file accounts for public record at Companies House and submit an annual return on a regular basis.  Company law applies equally to the largest public limited company floated on the stock exchange to the smallest one shareholder, one director limited company (your contracting company).   However, on a practical level it is not as scary as it sounds!

Umbrella Company

An umbrella company is a company owned by someone else for whom you chose to work.  In law, you are an employee of the umbrella company.  The umbrella company signs up with an employment agency which finds work for the employee (you).

Tax differences

Limited company

As a director and shareholder you can split your remuneration between salary and dividends.  If you choose your salary carefully, you will not pay employee’s national insurance contributions (12%) and your company will not pay employer’s national insurance contributions (13.8%) on the salary that you receive from the company.  A company can pay dividends out of  accumulated profits to its shareholders (you).  For each £90 the company pays, you are taxed on £100, however, up to the 40% tax limit, your dividend pays the tax due to you by the tax credit that goes along with it.

Umbrella Company

Umbrella companies invoice and collect the income due to their employees.  You must be able to trust that your umbrella company will collect and quickly pass on your net earnings to you.  There have been horror stories of umbrella companies going bust leaving the contractor high and dry and out of pocket.

Like any other employee of any other company there are some expenses that you are allowed to offset against your employment income.  In the past umbrella companies have been too lax in the expenses that they allow employees to offset against tax.  HMRC have adopted a much tougher line on expenses that are deducted from an umbrella employee’s income.  You must remember that a valid receipt for any expenditure must be kept and must follow the HMRC’s extensive guide on what and what is not allowed to be deducted in order to be deductible against income.

Take home pay comparison

Since there are no national insurance breaks and dividend breaks if you are an employee, the take home for an umbrella company employee is typically etween 55% and 65%.   One of the things you must realise is that when you become an employee of an umbrella company, the umbrella company is required to pay employer’s national insurance contributions which equate to 13.8% of your earnings above £7,956 per annum.  The company will charge you that to ensure they are not out of pocket.  So in effect, you are worse off than if you worked for someone as you are paying both employee’s and employers national insurance contributions.

If you run your own limited company take home pay is between 70% and 80% depending on your total income.

You may well see umbrella schemes promising take home rates of 90% of invoices pay.  These are more aggressive in terms of the risk of being challenged by HMRC and often rely on tax loopholes involving employee benefit trusts and loans involving foreign exchange losses.  If you use such schemes you should expect an HMRC challenge at some point an we would recommend adopting a prudent approach to keeping some money aside for any potential taxes, interest and penalties that may be payable in the future.

Scheme providers will assure you that their schemes are fully compliant and covered by legal opinion.  However, that’s all that is, learned opinion, and not a fact.  HMRC are very slow at prosecuting cases but they are relentless and will still be around long after your umbrella provider has disappeared.

How to choose?

The perceived wisdom is  that if you are likely to be contracting for less than six months or have expected earnings of less than £25,000 per annum then you are probably best served using an umbrella company.  We do not entirely agree with that.  We think that if you find an accountant charging at the right level, you should still be able to achieve significant savings compared to signing up with an umbrella company.

If those conditions do not apply then it is likely that setting up your own limited company will be more tax efficient and cost efficient for you.

You need to be comfortable being a director of a limited company and you need an advisor who can help you through it.  We think that running a limited company to deliver personal services is not time consuming nor complex.  We think that it probably takes 1/2 hour per month and £1,000 per year on accountant’s fees to run a limited company with the right advice.  You will save more than that in national insurance contributions.  Call or email us for a no obligation personal illustration.

Advantages and disadvantages

Limited company

You have a created a separate legal person and the law wants to look after that person.  There in administrative burden.  We have calculated that, well advised by a reputable accountant, this burden need not be more than 5 hours a year.  You will need to issue invoices and keep track of your expenses and approve your year end accounts and tax returns.  You get more tax breaks e.g. you may expense your mobile phone usage and reasonable subsistence expenditure and the cost of a laptop .

Umbrella company

There is little administrative burden and the contractual relationship is simpler but the tax breaks are less.  Yo will pay PAYE national insurance.  You need to make sure that you can trust your umbrella company to invoice, collect and pass on your net earnings.

A story from the contractor market

We have taken enquiries for professionally qualified individuals paying nearly £200 per calendar month to umbrella companies.  Three points struck us:

  1. the individual was certain they were caught by IR35 when even that was not necessarily the case (which was why they were using an umbrella)
  2. The individual was unaware that she was paying both employers (13.8%) and employees (12%) if you work for an umbrella company
  3. For less than half that cost PDS could perform a “deemed salary” calculation within our normal fee structure.  Deemed salary is a calculation on which NIC and PAYE taxes are calculated if it turns out that you fall inside IR35.
  4. The individual was unaware that she could have purchased up to £100,000 of IR35 tax liability cover for less than £1,000.  This means she could have contracted through her limited company, paid less tax and bought at a lower cost than it was costing her to work through an umbrella company!

The bottom line is that the individual was over paying her umbrella company ( a big player in the market) unnecessarily.  They clearly were not going to discourage her thoughts that she was caught by IR35.  Our feel was that she was not caught.


If you have any questions please contact us at PDS Accountancy where we be delighted to help you.

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