How to become an IT Contractor - Becoming an IT Contractor

One of the most frequently asked questions by new contractors is whether they should set up their own limited companies, or trade via an umbrella company scheme.

There are several factors you should consider before making this move:

Limited Company

If you set up a limited company, you will typically draw a small salary, and take most of your income in the form of dividends. This is the most tax efficient way of contracting, as dividends are taxed at a lower rate than a PAYE salary, and no National Insurance contributions are payable on dividends.

As a limited company director, you will take on a number of legal responsibilities. You must ensure that you comply with administrative and financial deadlines demanded by both Companies House and HMRC. If you hire a good contractor accountant, they should deal with most of these responsibilities on your behalf, but you are ultimately responsible to ensure that your company accounts, Annual Return, VAT returns and other documents are submitted to the correct authorities accurately, and on time.

If your contract is caught by the IR35 rules, then you will have to draw your income down via a deemed salary, together with a 5% 'expenses allowance'. Despite falling under the IR35 rules, you will still be at a tax advantage to umbrella company employees. You can claim VAT back on expenses, claim the 5% deduction for overheads, make up to 3.5% extra under the Flat Rate VAT scheme. However, the tax benefit of working under a limited company structure is significantly reduced.

Read more in our limited company section.

Umbrella Company

Under an umbrella company, you become an 'employee'. You sign a contract with the agency, and they sign the contract with the agency or client. After you submit your invoice/timesheet to the umbrella company, the umbrella invoices the agency and takes care of all tax and administrative paperwork for you. This is a 'hassle free' solution which may suit many contractors.

Your umbrella company will pay you after deducting income tax (PAYE), national insurance contributions (NICs), and any other agreed deductions - such as their service charge.

If your contract is caught by IR35, it makes no difference to an umbrella company contractor, as you are already paying full PAYE and NICs on your earnings. Some umbrella companies say that they are "HMRC compliant" or "IR35 compliant". These are just marketing phrases - there should be no difference in the way contractors are taxed between different umbrella companies.

Read more in our umbrella company section.

Limited or Umbrella?

Essentially, there are five key factors to take into account when choosing which company structure to use:

1) Do you want to run a business, or do you want a completely 'hassle free' solution?
2) Do you want to be in control of your financial affairs?
3) How important is maximising you post-tax income?
4) Are your contracts caught by the IR35 rules?
5) How long do you intend to contract for?

If you do not want to run a business or deal with any administration, or you are only expecting to contract for a brief time, then setting up a limited company is probably not for you. An umbrella company can provide you with a hassle free way of contracting.

If you are set on contracting for some time, want to maximise your income, and do not fall under IR35, then the limited company route is probably right for you, although there are still some benefits to running a limited company even if you are caught by IR35.

So, make sure you consider both routes from a personal as well as financial point of view, and if you need help - make sure you consult a specialist IT contractor accountant first.

As Phil Richards from BFCA Limited Chartered Accountants told us:

"At the end of the day the choice a Professional Contractor or Freelancer makes about running a Limited Company should be because they want to run their own business; and enjoy the freedom and independence that comes with the responsibility. My experience has led me to believe that in the current HMRC regulatory environment you would be better to make the decision for the right reasons and not just for financial reasons, that way you will enjoy running your company, being an independent entrepreneur, and enjoying the fruits of your hard work."

Limited or umbrella calculator

You should download our limited or umbrella company calculator to work out what your post-tax income will be depending on your choice of business structure.