Which is best for contractors, umbrella or limited company?

Should contractors work through an Umbrella or through their own Limited Company?

There are specific times when you'd consider an Umbrella more beneficial. But when it comes to applying for a mortgage, Limited is always better.

Becoming a Limited Company owner/director, you take on the mantle of a tangible business.

As such, in a mortgage lender's eyes, you're displaying intent, a long-term commitment.

Moreover, you've positioned yourself to run a contractor business in the most tax-efficient manner. A specialist underwriter will get that the minute they see your application. But getting your application before such an underwriter is often where most contractors' mortgage bids fail!

Let's make no bones: I'm not talking small change here. If you earn £30k+ per annum, the benefit of limited company deductions far outweigh those of an Umbrella. These savings should reflect in what a lender will use to work out how much you can afford to borrow.

It's simple maths: the more income at your disposal, the greater the potential mortgage you can borrow. I'll quantify that. These advantages apply if you approach a lender (or one of their brokers) who understands contracting!

What are the key differences between Umbrellas and Ltd Companies?

As a rule, Limited Company contractors retain more of their income than Umbrella 'employees'. Nine out of ten independent professionals would be better off working this way*.

But in reality, nothing like 90% of contractors go the Limited Company route. They're missing out, big time.

Through an Umbrella, you're availed of far fewer tax breaks than limited company owners.

*The switch to Private Sector on-payroll in April 2020 notwithstanding. More details to follow (after Spring Budget, 2020).

A quick word on expenses

Umbrellas claim expenses on your behalf that would otherwise be off limits as an employee. That said, HMRC is whittling down what classes as a viable expense.

The Umbrella will process your timesheet and work out your tax and NICs after expenses. And, yes, they will deduct a fee for the privilege. But that fee pays for itself in what they save you in tax.

Even then, any claimable expenses amount to nothing like those you'd get through your own ltd. co. business.

The flat rate VAT system is another consideration for limited company contractors. If you qualify, you get to retain some of the VAT you receive.

How does National Insurance work, then?

Either way you work, you're subject to both Employees' and Employer's NICs. But here's where the gulf lies between the two ways of working.

The best way to prove the vast difference is with an example. So, let's say you're a contractor, working through your limited company.

Every week, you pay yourself a typical salary of £166 (based on 2019/20 taxation). The rest of your earnings you draw down in dividends. You can pay yourself so little as director's earnings are outside minimum wage classification. Why you'd choose to do that we'll come to in a minute.

As either a permanent or umbrella employee, you wouldn't have this flexibility. The majority of your earnings would be subject to PAYE and associated deductions.

This is where limited company contractors win hands down every time.

Those dividends you draw do not get included in your National Insurance Contribution calculation. That means you can reduce how much NICs you pay by increasing your dividends.

Thus, the amount of tax you save compared to umbrella contractors is eye-watering.

Agencies tell me: "Go through an Umbrella; don't worry: it's easy!"

First things first: agencies can't make you go through an Umbrella Company. They may push you towards one, and in some instances, they're right to do so. Perhaps if you're on less than £35k or HMRC have classed you as 'inside IR35'.

But there maybe an underlying reason. Some agencies get a kickback for referring contractors to an Umbrella Company. In effect, the agency earns off you and from your new 'employer'. Nice work if you can get it.

It's only business. You make up your own mind.

If you're the best fit for the job, you should win the contract. Whether you're a limited company owner or sole trader shouldn't matter. They shouldn't refuse on the grounds that you won't go the Umbrella route!

Where an Umbrella might be advantageous

One thing you should consider, regardless. An Umbrella company set up is more straightforward than running your own company. Yes, you'll sacrifice some of what you could take home. But many contractors are willing to pay those fees for the easier life.

Also, if you're looking for a stop-gap role or are between jobs, think about your options. Ask yourself, is setting up a limited company yourself worth the hassle?
An Umbrella will serve that purpose.

But if you're hoping to build a successful contractor business, then Go for it! Incorporate your limited company. Hire an accountant. Get your business stationery ordered and marketing organised. You'll be a great deal better off in the long run for it.

Are Umbrellas Dodgier than Limited Companies?

Without the right guidance, you can sail close to the wind either way you operate. With your limited company, a contractor-savvy accountant will see you right.

While most UK-based Umbrella companies understand IR35, the tide's changing. Following December's Autumn Statement, they face a double-edged challenge.

The tax man invited interested parties to look at tax relief for temporary workers. In particular, those contracting for "employment intermediaries such as 'umbrella companies'".

Whilst the Chancellor highlighted travel expenses in December, his proposals may be a catalyst to something much wider. Tax avoidance and employment rights are almost certain to be on the agenda.

We know that undisclosed specific schemes are on the tax man's radar, too. So, we can expect investigations into offshore trusts to resurface.

Tailoring accountants to your business

Plus, HMRC even has more budget to strengthen its DOTAS task force. That means the enforcement of the Disclosure of Tax Avoidance Schemes legislation will tighten.

The main problem Umbrellas will face is their generic accounting methods. As a contractor, you offer a unique service or skill set. It's hard to imagine a one-size-fits-all system for high earners, such as IT Contractors.

A bespoke accountant will look at what's best for you, your circumstances, your business.

Their knowledge of limited company structures will help you reduce your tax liability. But they'll do it in a way that best proves you're not a disguised employee.

If the tax man sees you're operating outside IR35, they're less apt to investigate. Don't just take our word for that, though. Every contractor should undertake an IR35 audit. Ignorance is not a defence you want to take to court.

An accountant? Don't they cost a fortune?

So, we've used that dreaded word: accountant. Many contractors choose the Umbrella route to avoid having to prepare their own accounts. That's fair comment, but it’s somewhat missing the point.

Most contractor accountants charge less per year than a typical Umbrella deducts in fees.

Another get-out clause contractors use is tackling running the actual business. All the imagined paperwork when you need to concentrate on continuity, learning and marketing? That's besides actually carrying out your service for the client.

Yes, a contractor-savvy accountant can carry some of the burden. They'll show you further savings, too, cementing your relationship. Use those extras to your advantage.

It could save you thousands of pounds every year between now and when you retire.

But there's no easy way of soft-soaping the bottom line. To get the ultimate reward, you've got to carry the can at least part of the way to the finish line.

Okay. If you're testing the waters of contracting, you may want to try an Umbrella first. That's understandable. You'll earn on a PAYE basis. You won't have to employ an accountant.

But if you're earning over £30k per annum, think twice. You'd be better off creating your limited company. If you like contracting but not accounting? Then entrust your accounts to a responsible third party. It will pay dividends in the long term.

What mortgage brokers can do for you, whichever way you work

As an Umbrella employee, you can still get a mortgage based on your contract rate. The options we have, though, are fewer and less flexible. But lenders are coming around.

They'll still assess you on your annualised contract rate. But they impose certain restrictions that don't apply to limited company contractors.

Mortgage lender possible objections to Umbrella Contractors

The first condition is that you must work for a UK-based Umbrella company. Those dreamed-up offshore trusts and schemes may squeak past IR35. But that way of operating won't sit easily with a mortgage underwriter.

A lender may also write to your agency to confirm your income. This route often involves determining your net earnings. Notice the word 'net' (not gross) contract earnings here.

Compare that to contracting through your own limited company, where they'll underwrite you on gross earnings. This is called 'contract-based underwriting', where a lender uses your gross annualised contract rate.

Say you've traded under your own steam for three or four years. You can access mortgages based on your contract OR on your limited company accounts.

This flexibility gives you and your broker options. You can access self-employed mortgages (full-status, based on accounts) and contractor mortgages, putting you on par with permies.

Mortgage underwriting: Limited Company vs Umbrella

Use a specialist broker to bypass the templates created for PAYE salaried workers. Bespoke contractor mortgage brokers don't work like in-branch bank staff. Instead, they deal with underwriters at head office.

Having this direct line to senior underwriters gives us insight into how they think. Heck, we've even developed the process with lenders unsure of how it all worked.

So we know how they think. We know how underwriters compare the respective commitments of each type of worker.

In their favour, a Limited Company contractor has, more often than not, invested in:

• an accountant to optimise for the genuine tax breaks on offer;
• creating a limited company, separating themselves from debt;
• a tangible business, with its own brand and perceived value.

Compare that to an Umbrella worker.

True, Umbrella contractors know that whatever money they pick up is theirs. And they have little involvement with paperwork, minimising the opportunity for error.

But this route doesn't maximise their earning potential. Nor does it imbue a sense of ownership.

The responsibility of creating a long-term sustainable business speaks volumes about the contractor's intent. And let's not underestimate that in the eyes of someone about to approve a huge loan.

What do we advise?

In our experience, presenting an Umbrella worker's payslips only confuses lenders. They're not the same as those that a director/employer using RTI would produce.

Even 'contractor-friendly' banks and building societies struggle with the intricacies of such payslips. See it from their point of view. Who volunteers to pay more National Insurance if they can claim so little of it back? That's what an Umbrella payslip implies.

These lenders, they have a point.

What if I'm only using an Umbrella as a stop-gap?

What happens if you're only dipping your toe in contracting waters with an Umbrella?

The lender will consider if it's really the right time for you to be taking on a mortgage. How will you meet repayments if you decide it's not for you once your contract's finished?

This is how it works.

Reducing risk: it's always the bottom line

The more longevity we can prove, the greater your chances of mortgage success. Not only for the approval of a lender. But also for your own long-term ability to meet the mortgage repayments.

If you've appointed a contractor accountant, even better. They'll help you—and us—keep paperwork to a minimum. This will eliminate any concerns over evidence of earnings.

Accountants also know how to display a limited contractor's true earning potential. This is critical to help your specialist broker package your application in the most efficient manner.

As a result, the underwriter can clarify relevant earnings for affordability purposes with confidence. You don't want to give an underwriter any wiggle room. Stick to the facts, packaged in the way they like to receive them.

Lenders may also perceive lower risk if your business is a separate liability. As mentioned at the start, incorporating a business shows intent. In many ways, acting like a business thereafter backs up those intentions.

And that's what it's all about. You must prove that your contractor business supports your mortgage application. If it's raining, a solid roof over your head beats relying on an umbrella every time!