This is a question faced by more and more contractors today in considering what they should use and in this article we’d like to try to demystify the pros and cons of each.
For simplicity, it’s easier to think of a personal service company as a simple limited company. On the other hand if you’re not already familiar with umbrella companies then you’ll find out more about them here.
Here are the key differences:
1. National Insurance (NI). With a limited company there are substantial savings on National Insurance Contributions to be made because unlike umbrella companies, limited companies aren’t faced with paying both employer’s and employee’s National Insurance Contributions. This difference shouldn’t be underestimated because it could run into thousands, even on a daily rate of £200.
2. Flat rate VAT. The flat VAT rate scheme is designed to simplify taxes and offers attractive incentives for contractors. In a nutshell, it enables VAT to be charged at a higher rate than it has to be paid back to HMRC. Once again, even on a very conservative £200 per day, the savings to be made from this arrangement can be substantial, but significantly lower than the savings to be made in respect of NI. An umbrella company does not allow contractors to take advantage of this saving.
Thereafter there are the longer term tax planning opportunities to think about as well as how ‘hands on’ you want to be in the running of your affairs.
There is no getting away from the fact that running a limited company is more complex than using a PAYE umbrella company. However, it is fair to say that the take home pay percentage is somewhat different too. It is reasonable to assume that in a limited company set up, you should expect to hold on to around three quarters or more of your earnings, whereas with a an umbrella company you are looking at taking home only somewhere between 60 and 65% of your total income.
What about IR35?
IR35 was introduced in 2000 as a way of combatting tax avoidance through use of personal service companies. In the media personal service companies have been increasingly portrayed in the media as having been set up purely for the purposes of avoiding tax.
Essentially the IR35 scheme was set up to weed out the people who were effectively employed by their clients but thanks to the way their affairs were set up through companies were in receipt of dividend payments instead of salary. By structuring their affairs this way, they managed to avoid significant sums of NI.
The IR35 rules are applied to any contractor who doesn’t meet HMRC’s definition of self-employment. Contractors falling under these rules will become liable to Schedule E taxation and NI after they have deducted their legitimate expenses. The most effective way of avoiding the IR35 net is to make sure that in as many as possible of your activities you are viewed as self employed by the HMRC.
Issues with expenses
The key with expenses is to claim back only what you’ve spent and this is where the issue often arises with umbrella companies. In cases where over payment of expenses has been made to employees, HMRC will look first at the employer and then look to the employee to make good the shortfall of unpaid NI and tax payments.
In certain cases, it has been found that the employee is paid expenses where no expenses are due, and this is a clear case of avoidance. However, the money saved on employer’s NI contributions isn’t always passed on to the employee.
Where contractors make a choice to operate under an umbrella, then they make that decision themselves, however, certain employees have slipped into the net unknowingly and in some cases unwillingly because they need the work.
So the answer to whether a limited company (Personal Service Company) or an umbrella company would work best for your situation is a complex one and the key to getting it right is to seek in-depth professional advice from someone you trust and to review the situation regularly as your contracts change and develop.
If you’d like to discuss the pros and cons of the different options, give us a call on 0845 606 9632.