An friend of mine asked me what he needed to know about contracting.  Currently in a well paid job as a IT PM in a major banking organisation, he said he might consider contracting in the future but didn’t know a whole lot about running a limited company and didn’t know the start-to-finish of the process.

This article attempts to explain what he needs to know.

Umbrella or Limited company?

The perceived wisdom is that if you are only going to contract or freelance for a short period then using an umbrella company is the way to go.  It’s easy to sign up to (you genuinely don’t have to do anything but sign up) but most umbrellas charge a hefty fee for providing their services and aside from deducting some expenses, you still suffer PAYE and NIC (national insurance contributions) on your contract income.  The easy part is that you can walk away from an umbrella company fairly painlessly.  Takehome pay is often estimated at between 65% and 75% of your contract income.

Limited company

If you set up a limited company you create a separate legal entity to you.  there needs to be at least one director and one shareholder (usually you)  and there are some obligations that go along with the existence of a limited company.  Without further consideration, the apparent hassle of running a limited company puts some contractors off but without doubt it is the simplest means to attract tax benefits.  The main benefits are:

  1. the flat rate VAT scheme allows a company to settle its VAT liability as a straight percentage of sales which is less than the 20% VAT rate.  An example is that say you invoice a sale at £1,000 with 20% VAT on top of £200, making £1,200 in total.  You settle the VAT liability on sales (output tax for the technically minded) by paying HMRC a “flat rate” of, say, 15.5%.  This means that you pay HMRC £155 and keep £45.  HMRC aren’t stupid, the reason they let you pay them less than the full £200 is that you are not allowed to claim VAT back on anything other than certain large purchases.  However, for contractors with few VAT’able expenses, the flat rate scheme provides an enhancement to their income.
  2. payments can be optimised so that the company and the owner does not pay NIC (saving of 13%)
  3. dividends make up most of the income extracted from the company and the fact that you have control over dividends means that if you are earning contracting revenues near to a tax threshold, you can delay taking income out until a more convenient time.
  4. Expenses which are “wholly and exclusively”can be deducted from income e.g. cost of a mobile phone, laptop etc.  However this is not a panacea for charging everything but the kitchen sink as a company expenses!  HMRC has a 100 page booklet on what can and cannot be charged.

IR35, Managed Service Company (MSC) legislation

In order to attract the efficient tax treatment afforded by operating through a limited company, your contracts need not to be caught by legislation designed to stop tax avoidance.

IR35 is designed to stop tax avoidance by taxing you very similarly to a regularly paid employee working under PAYE.  The rules and tests to see if you are caught are complex and dependent on case law.  Common sense and/or intention is not necessarily a determining feature.

There are two main things to remember about avoiding being caught by IR35

  1. The contract between the agency and your limited company must be drafted appropriately, and
  2. Your behaviour and treatment at the client’s site must be consistent with a business-to-business relationship

You need to ensure your accountant is competent to advise you on whether your contracts are caught and how to calculate your tax if a contract is or is not caught.  The good news is that most agencies that find work for contractors operating through limited companies are familiar with IR35 although not all of their contracts are well drafted to avoid the legislation.

You can purchase insurance to cover you from the possibility of being challenged by HMRC.  If you are interested in understanding more of the detail, please read our IR35 Guide.

The MSC legislation is targeted at companies who get involved with setting up and controlling limited companies which they don’t actually own for third parties.

The way to avoid MSC and IR35 legislation is to think, act and work like a genuine services provider.  Don’t think like an employee, sign employee like contracts or act like an employee at the client’s premises.  For more detail see our IR35 Guide.

Invoices and expenses

You will need to issue invoices probably with VAT and maybe with expenses reimbursement.  Your accountant can give you a proforma invoice to send out or you can use accounting software if you are really keen.  It is usually more efficient for the contractor to send out invoices but, for a small additional charge, your accountant can do it for you if you are not confident.

You need to log your company related expenses.  The expenses (and any VAT) need to be logged and sent to your accountant.  They will advise you whether an expenses is deductible for tax purposes or not.  There are few new ruses to charge expenses to your company that have not already been tested by HMRC.  Your accountant should be able to tell you what is reasonable and what is not.

A lot of our competitors do not include book keeping so be clear what is and is not included in your monthly package.  We are happy to receive a spreadsheet log, scanned receipts or bank/credit card statements or even a pile of receipts if you would like.  We won’t store receipts for you (it costs too much money) but we will do the book keeping in a way that suits you and is efficient.

Receipts and invoices should be kept for at least 6 years but for an average contractor that is one lever arch file a year.

Other Limited company stuff

  1. You have to file accounts at Companies House.  For small companies this is just a balance sheet and notes
  2. You have to submit detailed “statutory” accounts to HMRC.  For any company this is a detailed set of accounts which must disclose more detail as prescribed by the legislation and includes a statement of income (profit and loss account)
  3. A limited company must document and report certain decisions to companies house and must file an annual return.  For example, you have to make filings when share capital is changed or when directors change.
  4. A director can be personally liable for the debts of a company under certain circumstances where the company trades and is insolvent
  5. Company’s can be “dormant” when there are no transactions to report in a year but must still file accounts (which should be easier to prepare for the accountant given there are no transactions)


Running a limited company need not be a lot of hassle if you choose the right advisor.  It requires some attention but most of the compliance related activities required for HMRC and Companies House can be attended to by your accountant.

Make sure that your accountant is well versed on the issues that affect you, that they are regulated and professionally qualified and are accessible when you need them.  We are all of these at PDS Accountancy.  Call us and we will advise you.

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