Why contractors choose Limited Company payment structures

Leaving permanent employment is a big decision for most people. Yet many do when they realise they can earn much more as an independent than as an employee.

Stormy, but often lucrative, waters of contracting or freelancing call to the intrepid adventurer. And the siren song of higher day rates is just too much of a temptation.

But before launching yourself into the deep, take a moment 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?

Who's going to work out what you can claim as tax relief and what you can't?

And how can you juggle it all to make it easy for your customers to deal with you? This is a hot topic, close to the hearts of many first-timer contractors. And rightly so. Here are some pointers to help you navigate company formation and running your business.

Newbie contractors, just starting out

Most contractors for whom we get a mortgage work through their own limited company. The key reason is that going limited offers the most tax-efficient business structure. Plus, it has many other advantages over alternative payment structures.

Before placing you into a contract role, recruitment agencies often ask you to either:

• create a limited company under your own steam;
• work through an umbrella company.

They ask this 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:

• the limited company option;
  • you may have an idea of what that entails, even if you don't quite know how to set yours up;
• operate through an umbrella payroll service company.

Why would you go through an Umbrella Company?

As we've said, running a limited company is the most tax-efficient way of working. But some contractors choose to work through an umbrella company.

Why would they do that and sacrifice some of the freedom and income contracting brings?

Going through an umbrella, they are becoming a PAYE employee once more. But 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 misconception we hear from inexperienced contractors concerns the day-to-day running of a limited company. Often, they imagine it's both difficult and time-consuming.

It needn't be such a challenge if you set up the basics, a solid platform. Then, using a limited company is no more challenging than other forms of trading structures. One key element is appointing a competent accountant.

Working through your own limited company, you'll soon realise that delegation is key. Don't worry. No one expects you to know all this off the top of your head.

Getting your fair (and first) share

First, you become a shareholder in the limited company you create. This single act enables you to adopt an optimised income strategy.

Your accountant will implement a simple tax planning strategy to help you realise significant tax savings. This, in turn, allows you to take home in the region of 75-80% of everything you earn.

How so? Limited company contractors don't pay themselves as a traditional salaried employee would. This is the second notable aspect, and part of the tax-planning strategy.

Off-payroll: receiving gross income into your limited company

Your income is no longer a salary, per se. The rate you earn goes into your company, gross, before tax and NICs. 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 more than 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?

There are several ways to incorporate a company:

• go direct, via the Government's 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.

If you appoint your accountant on an ongoing basis, they may set you up with a company for free. Then, as you grow your business, that relationship will flourish in tandem.

What documentation do you need to incorporate a limited company?

You'll need to provide various details so that you can complete company 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 you pay depends on the type of industry you're in or service you provide. The Government has produced a list of who pays what amount of VAT that you might find useful.

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.

Final Thoughts

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 so not the reason you got into contracting in the first place.

The onus is on you to reduce the workload further, so that you can focus on providing your service. A specialist contractor accountant can deal with HMRC and Companies House on your behalf. Appointing one is the first big step to the financial freedom you crave right now.