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Why contractors choose Limited Company payment structures
Posted by John Yerou
on April 13th, 2015 18:52pm in
Last Updated on October 15th, 2019 13:52pm.
Casting off from the shores of permanent employed is a big decision. The stormy, but often lucrative, waters of contracting or freelancing await the intrepid adventurer. But before launching yourself into the deep, stop. Just for a moment, at least, to consider your options.
In particular, you need to think about your new business. What’s the best way to minimise your long term tax liabilities? How, at the same time, can you maximise your income? And how can you juggle the two to make it easy for your customers to deal with you.
This is a hot topic and one close to the hearts of many first timers.
Most contractors for whom we secure mortgages work through their own limited company. The key reason is that going ltd. offers by far the most tax efficient business structure. Plus, it has many other advantages over alternative payment structures.
Newbie Contractors – Just starting out
Before placing you into a contract role, recruitment agencies often ask that you either:
- create a limited company under your own steam;
- work through an umbrella company.
This is so that you can both receive remuneration and meet your tax liabilities.
Being a self-employed newbie, you need to decide which payment structure suits you best.
You have two main choices. One is the limited company option. You’ve maybe got some idea of what that entails even if you don’t know how to set yours up. The second is to operate under what we call an umbrella payroll service company.
As we’ve said, running a limited company is the most tax efficient way of working. So why do some contractors choose to work through an umbrella company? They are, for all intents and purposes, becoming a PAYE employee once more.
There are justifiable circumstances where an umbrella is a good fit. Here are just a few of the reasons we’re given by contractors working this way:
- it’s a short-term stop-gap while looking for other work;
- at some point, they’re planning on reprising a permanent role;
- it’s much less hassle than setting up a limited company;
- they don’t fancy having to submit annual returns and registering for a self-assessment.
- the taxman has caught them inside IR35;
- as such, they’re unable to reap the benefits of working through a limited company;
- it’s a measure to ensure they secure the contract;
- some agencies may dangle a juicier carrot, if you join their preferred Umbrella Company.
Granted, being a temporary measure or caught inside IR35 are bona fide reasons. Otherwise, there’s no legitimate reason why contractors need an umbrella company at all.
Limited Company Contractors
One of the greatest misconceptions we hear is about running a limited company. Often, first timers imagine it’s both difficult and time consuming.
Nothing could be further from the truth. Operating this way is no more challenging than any other form of trading structure. That is, if you have a competent accountant.
This is the truth about working through your own limited company. And don’t worry. You’re not expected to know any of this as a newbie.
So, first, you become a shareholder in the company you create. That’s the key difference. This enables you to adopt an optimised income strategy.
By adding simple tax planning, you’re able to realise significant tax savings. This, in turn, allows you to take home in the region of 75-80% of everything you earn.
But limited company contractors don’t pay themselves like traditional salaried employees. That’s the second notable aspect.
Your earnings are no longer a salary. Yes, what you earn goes into your company. But shareholders draw down most of their income in the form of dividends. Key here is that these dividends aren’t subject to National Insurance.
As a company director, you can also split shares between you and your spouse. You can then time dividend declarations so that they optimise each year’s tax-free allowances.
That all sounds technical, but remember: a contractor-savvy accountant will organise this for you. What’s more, they often pay for themselves in the deductions they save you alone.
For more information, see our dedicated guide: how should contractors run their limited company?
How do you form a company?
Great. You want to form your own limited company. There are several ways to incorporate a company:
- go direct, via the Companies House Web Incorporation Service;
- choose an intermediary (a company formation agent) to do it for you;
- appoint an accountant well versed in the contractor lifestyle.
Each method will produce the same direct outcome. But you may prefer to use an accountant if you’re new to contracting. Here’s why.
An accountant may set you up with a company for free if you decide to appoint them on an ongoing basis. As you grow your business, your relationship with them will flourish in tandem.
What documentation do you need to incorporate a limited company?
You will need to provide various details to Companies House to complete the formation:
- Form IN01, which captures the details of:
- each proposed director;
- shareholding information;
- your proposed company address;
- Memorandum of Association, which contains basic details of the initial subscribers;
- Articles of Association, which describe how you will run the company;
- Companies House provides ‘model’ articles in the majority of cases.
During the incorporation process, you must choose a suitable company name. There are certain ‘sensitive’ words and expressions that you cannot use. Your name can’t imply membership of a professional body when you’re not, for example.
In general, we’d suggest you stick a moderate or generic name. You and your accountant will use it on your future accounting and contract documentation.
It’s often overlooked, but you only get one chance to make that first impression. You’ll soon see branding as an integral part of your new corporate identity.
But don’t feel as if the first name you think of wasn’t so good in hindsight. You can change your company name in the future should you need to.
There’s much more on our dedicated guide to Limited company registration.
Flat Rate VAT Scheme (FRS) for LTD Contractors
The Flat Rate VAT scheme is a Government incentive designed to help simplify taxes. You charge VAT on your invoices at 20%, but only pay back HM Revenue and Customs at a lower rate.
The rate in your first year is just 13.5% of your gross invoiced amount. It’s 14.5% in thereafter, representative of a 1% discount in your first year.
For high-earning professionals like IT contractors, you may earn enough to charge VAT. For any contractors who do, consider the Flat Rate VAT scheme.
Here, contractors are likely to benefit from further potential savings. They have few costs, thus little in the way of input VAT to reclaim.
The limited company route is the most common structure for contracting. It provides a significant tax advantage over the umbrella route.
The caveat is that you will have to undertake a modest amount of administration. This is to comply with your director’s obligations to keep your accounts up-to-date.
In practice, the work involved in running a contracting company is minimal. But it’s unfamiliar territory and not the reason you’re getting into contracting.
The onus is on you to reduce the workload even further, so that you can focus on your service. A specialist contractor accountant can deal with
Author: John Yerou
John Yerou is a pioneer of contractor mortgages and owner and founder of Freelancer Financials, Contractor Mortgages®, C&F Mortgages and Self Employed Mortgages, trading styles and brands of the award-winning Mortgage Quest Ltd.
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