8. Limited or umbrella? Making the right choice

The umbrella company vs limited company debate is a hot topic and often the first real decision for aspiring contractors.

An umbrella company and a limited company each represent two of the most common business structures that contractors use. But, which one is the best option for you?

Quick Guide: Limited Company

If you set up a limited company, you are the company director and have a number of statutory and financial obligations to fulfil. Most companies directors use a specialist contractor accountant to help them with this.

Contracting through a limited company is the most tax efficient way of operating. You pay yourself a salary (which is usually at the basic rate tax band) and the remainder of your income is drawn in the form of dividends.

You do not have to pay National Insurance contributions on your dividends. However, changes to the tax laws in April 2016 mean the maximum you can draw out of your company is £16,000 before you are taxed.

Quick Guide: Umbrella Company

If you join an umbrella company, you are an employee of the scheme. The umbrella company acts as a go-between for you and the client. Primarily, they organise payment for your contract work. You pay the umbrella company a rate (usually on a weekly or monthly basis) for this service.

While it is more tax efficient to work as a limited company, you do not have to make any long term commitments to contracting under an umbrella company. It’s a ‘hassle free’ route for many contractors.

What’s more, the IR35 is irrelevant if you work with an umbrella company as you are taxed as an employee.

Umbrella Company vs Limited Company

Let’s look at the pros and cons of each business structure from a range of perspectives:

Operating costs: you pay a weekly, monthly or percentage fee to your umbrella company. Under a limited company, you pay an accountant to manage your company’s tax affairs.

The fixed rates for an umbrella company and contractor accountant are often similar depending on the level of service your require.

Result: the operating costs are similar under both business models.

Tax efficiency: a limited company is more tax efficient than working for an umbrella company. Under an umbrella company, your entire salary is taxed via PAYE.

Our contractor calculators can help you to work out what you could earn as a contractor under both business structures.

Result: a limited company is more tax efficient

IR35: if you are caught by the IR35, most of the tax benefits of working as a limited company are lost. However, the IR35 is not relevant under an umbrella company.

Result: you are not affected by IR35 under an umbrella

Setting up: for a limited company, it only takes a couple of hours to register with Companies House. However, it can take a few weeks to register for taxes, including your Corporation Tax and VAT number. You can find out more information on forming a limited company here and Contractor UK’s Online Limited Company Registration and Formation Agent is available here.

Setting up with an umbrella company is usually instantaneous.

Result: setting up is a longer process as a limited company

Accounting and insurance obligations: contractors with a limited company need to compile regular accounts and complete annual accounts to Companies House. You also need to submit a Corporation Tax Return (CT00) every year and settle any tax liabilities, including your annual tax return. Your limited company also needs to pay for business insurances, such as professional indemnity insurance.

There is little to no admin if you work under an umbrella company. You do not need to complete a tax return, unless you earn additional income outside of the umbrella company. The fee you pay your umbrella company will usually cover your insurance.

Result: there are far more financial obligations as a limited company

Tax implications: with a limited company, you can take dividends when you need to. This is a flexible way to draw money from your business. You must pay your taxes at the correct rate and on time. You can also join the Flat Rate VAT scheme, which can further boost your take home pay.

Under an umbrella company, there are very few tax planning opportunities. The umbrella company deducts taxes and collects VAT before you are paid by them.

Result: you get more flexibility in your tax planning as a limited company

Getting paid and expenses: if you run a limited company, you must invoice the agency and chase for payment if it is not forthcoming. However, you can offset your expenses against the company’s tax bill. You must also set up a separate business bank account.

With an umbrella company, you must submit a timesheet and the umbrella company then invoices the agency. You do not have to chase the agency for payment, but make sure you choose a fast-paying umbrella company. However, there is little scope to reclaim expenses under an umbrella company. Additionally, you do not need to open a separate bank account.

Result: you must do the legwork as a limited company

Umbrella Company vs Limited Company: The Verdict

Your decision to work as a limited company or for an umbrella company will depend on how you intend to work - and with whom.

For an umbrella company, you have little control over your business and how often you’re paid, but you are freed from many of the common contractor headaches, such as chasing payments, accountancy admin and client negotiations.

An umbrella company is a solid choice if you are new to contracting and want to test the water with one client. Additionally if you are on a lower daily rate there may be very little difference in tax efficiency.

If you intend to work with multiple clients and are willing to pay a contractor accountant to manage your business, then you may want to work as a limited company.

With a limited company, you have a high degree of control over your business and pay less tax, but you also have a lot more administrative tasks to wade through.

What’s more, you will typically take home more of your contract rate by working through your own limited company.

Therefore, a limited company is a good option if you are dedicated to contracting and want to work with multiple clients.

The choice is yours but, before you make a decision, it's important that you consult umbrella companies and contractor accountants who specialise in the sector.

If you are still unsure about the pros and cons of umbrella company vs limited company for your work, you can find out more on the ContractorUK forum for information on limited companies or the umbrella company forum.