Umbrella Companies – A Guide for Contractors

Last Updated: 04-06-2024

Reading Time: 15 minutes

So. You've secured your first contract as an independent professional. You're with your recruitment agent, who says "Great. Now you need to find an umbrella company".

businessman holding red umbrellaWhat does that mean, exactly?

Or you may not be quite at that stage. Instead, you're mulling over leaving your permanent role to take up a contract offer.

You're not quite sure what that will entail. So, now you're researching ways to operate as a contractor, umbrella companies being one such way.

To help you make the right decision, understanding why umbrella companies were born may help. Moreover, what their role is compared to other options open to you, especially after the latest IR35 reforms.

Clear as mud? Great. Let's go.

Why do Umbrella Companies exist?

Umbrella Companies rose to prominence when IR35 tax legislation became statute 1999. The Government launched the legislation to catch what they deemed 'disguised employees'.

What's the definition of a disguised employee?

Imagine that you worked in a permanent role for a direct employer, as most people do. You and your boss agreed you'd be better off in the same job, but as a self-employed entity.

The boss would then make you redundant on Friday. But you'd then reprise your role on Monday but with a self-employed contract. IR35 was born to distinguish contractors from employees who'd traversed this route.

And, yes. It worked. Many contractors fell foul of the guidelines and deemed "inside IR35". Bye-bye savings on NICs and income tax. Hello years of scrutiny and higher taxes.

What is an Umbrella Company?

man walking on lightning bolt with umbrella (cityscape in the rain)In its simplest form, A PAYE umbrella company is like a standard UK limited company. But, it differs from a traditional PSC as it's operated by a third-party supplier.

The third party is the umbrella company. They adopt a role similar to an 'employer' on behalf of its contractor employees. Hence, you'll often hear umbrella contractors called umbrella employees.

The umbrella company signs a contract with the recruitment agency or end client. The contractor who'll be carrying out the assignment, in effect, works for the umbrella.

The umbrella provides many services to its employees. A PAYE umbrella treats all your income as salary. This means you pay employers NI, employees NI and PAYE on all your income.

In effect, they're taking away the headache of running the contractor's business. They:

  • process all timesheets;
  • raise invoices on behalf of the contractor;
  • take into account the necessary tax deductions;
  • then, pay its employees a salary after tax.

The result means the contractor working for a respectable umbrella needn't worry about the IR35 legislation.

How does an umbrella company work in practice?

Here are the steps you'll take if you join a UK-based PAYE umbrella firm. They assume you've already won a contract and your hours are set:

  1. the umbrella company (as your 'employer') signs a contract with your recruitment agency;
  2. you'll also sign a contract of employment with the umbrella;
  3. you fill in a timesheet for the time spent carrying out the contract on-site. You then pass it on to your manager to sign;
  4. submit your signed, completed timesheet, to both your recruitment agency and umbrella;
  5. the umbrella company will invoice the recruitment agency, who then bill the end client;
  6. once the umbrella company receives payment from the agency, they can prepare your payroll;
  7. your umbrella will process your payroll and pay you a salary after deductions;
    • this will include income tax, NICs, the pre-agreed umbrella fee, and any other deductions;
    • they will also reimburse you for any allowable expenses you have claimed;
  8. As your employer, the umbrella will apply a relevant tax code upon receipt of your P45 or P46;
    • this P45/P46 enables the umbrella company to maximise your personal allowance;
    • contractors will then receive a payslip to support their payroll;
  9. As an employer, umbrellas will also produce a P60 at the end of the financial year.
  10. And, once your contract/employment has ended, a P45.

What are the main reasons for choosing the Umbrella route?

There are certain circumstances that scream: great fit for an umbrella company. These hinge on your attitude to the contractor lifestyle and your gross contract value.

You need to decide whether your culmination of elements raises the decibel level. Umbrella companies:

  • are a hassle-free way of working for contractors earning below 25k per annum;
  • allow contractors to increase take-home pay (compared to working PAYE direct through an agency or client).
  • allow you to trial run a contracting career before making a long-term commitment;
  • are ideal if you plan to work as a contractor for only a limited period;
  • offer a bona fide way to work if you expect that most or all your contracts will be caught by IR35*.

* Do you suspect you might be inside IR35? If so, there's little or no financial justification going the limited company route.

You'd still have to pay full PAYE and NI contributions if caught. An umbrella company in this case would be a viable option.

One quick word of note. Be careful if you're overly influenced by an agency to join a specific umbrella company. Exerting pressure like this is illegal under the 2010 Bribery Act, but it still happens.

Beware of Dodgy Offshore Umbrella Schemes

For many years, offshore tax schemes have lured contractors 'to the dark side'. They promise a higher level of remuneration, but beware the true cost.

Offshore umbrellas market schemes to contractors stating they'll receive 85% - 90% retention. In other words, they keep much more of their contract income than by other routes.

But, offshore tax avoidance schemes are complex payment structures. These schemes filter a contractor's pay through an offshore third-party trust.

The trust then returns the money to the original contractor as a non-taxable loan. This allegedly does not have to be repaid! Make sense? No, we don't think so either.

HMRC have recently adopted a more aggressive stance on these types of payment structures. They're taking a "guilty until proven innocent" approach with their Accelerated Payment Notices.

The upshot is that members of offshore schemes may have to pay any tax due. But not at a preferred rate; they'll have to pay tax as if they were employees.

This may mean some liability at the 45% level, plus 2% National Insurance. HMRC are still deciding whether they can get the scheme approved. If they do, the scheme could mean tens of thousands of pounds in up-front payments!

Can I still apply for a mortgage if I'm using an Umbrella Company?

Contractors often ask us which is easier. Getting a mortgage as an umbrella employee or through their own limited company.

There's this misconception that contractors using an umbrella company have an easier time. It's actually the other way around. Contractors using their own limited company have more options than working through an umbrella.

If you're using your own Ltd company, you get two bites of the cherry when it comes to applying for a mortgage. To work out your affordability, different lenders will either:

  • work off your salary and dividend;
  • or salary and net profit.

There's another more contractor-friendly route. This entails applying for a contractor mortgage based on your daily rate.

If you use an umbrella company, the lender is likely to ask more questions, not less. Who employs you? Why do your payslips not look like an employee's payslips?

Why Umbrella Payslips Confuse Mortgage Lenders

calculatorIn theory, umbrella contractors should get mortgages with their payslips with little effort.

They’d present it* to a lender.

The advisor would work out affordability using their standard calculation.

And that would be the end of it: all relevant data uploaded to their mainframe, bingo! You get your mortgage.

In reality, such a straightforward deduction is a pipe dream. That’s because an umbrella payslip bears only a passing resemblance to a permie’s payslip. The part of it that breaks down income is another story.

It’s not so much the “gross salary” for taxation that’s the problem. The disparity between the gross salary and the gross invoice amounts is the hiccup.

*Pre-tax deductions: a tale of two payslips

An umbrella contractor can deduct certain ‘expenses’ before they pay tax. The eventual taxable amount will reflect these not insignificant elements. It’s these variables, and the sheer amount of them, that muddy the water.

Gross Invoice amount: the whole story

The Gross Invoice amount is straightforward enough. A contractor ensures that the hours worked tally up to those on the ‘invoice statement’. The same with the amount of days worked that count towards the invoice. The final check is for any holiday or sick pay claimed during the invoice cycle.

It’s straightforward multiplication and addition, the total of which should match the respective timesheet.

Gross Salary amount: the sub plot

But before the taxman takes his cut, an umbrella ‘employee’ can make pre-tax deductions. It’s these that produce the final Gross Salary and could include (but aren’t limited to):

  • any of the (diminishing number of) expenses availed of contractors today, including insurances;
  • these must be wholly relevant to your client’s work and over and above the rate agreed by the client;
  • the umbrella company’s fee (they don’t process tax, et al for the love of it);
  • contributions to pension funds, which may include any made by the employer/agency;
  • employer’s National Insurance contributions (yes, suck it up — it’s an inescapable factor of contracting);
  • any holiday pay accrued through the umbrella/agency;
  • similar sick pay, if applicable;
  • child care vouchers.

All the above the umbrella company will apply to the Gross Invoice figure. That, in turn, will produce a ‘Gross Salary’ figure that’s taxable by HMRC.

HMRC deductions will, like a normal employee’s, be:

  • Employee’s National Insurance contributions;
  • Income tax.

Not so difficult to understand when you’re in the know, right? But to an untrained advisor with inflexible software, the whole process is a nightmare!

Truth will out

If it was just a case of submitting your Gross Salary umbrella payslip, there’d maybe less of an issue. That part of your wage slip documentation does look like a normal PAYE payslip.

But the fact is, when you have to enter your income, you have to enter your true day rate. Or the ‘annualisation’ thereof: your day rate extended over 46/48 weeks.

That leads to you having to explain the often huge drop from your invoice amount to your taxable salary. To do that, you’ll need to show them your online payslip, or ‘customer statement’. That’s the bit of your payslip with all the pre-tax deductions on it.

This breakdown soon transpires into information overload for a traditional lender’s calculation. And talking of breakdowns, it gives the advisor trying to work out how to input it all onto the system one, too.

Basic wage workaround? Not so much of a Brucie Bonus

And it doesn’t stop there! Umbrella Contractors can also earn just statutory minimum wage for the hours they work. What tops up their salary is that they then earn a bonus based on the funds they generate.

Some mortgage companies only use basic wages when working out mortgage affordability. Commission or bonus related wages just don’t provide the security lenders are looking for.

In instances like this, banks will fail to grasp that you’re a professional contractor. That you’re only utilising a payroll service as a payment vehicle passes them by.

Enter, stage right: the specialist underwriter

It’s for these reasons that underwriters like specialist brokers to vet umbrella contractors’ applications. Underwriters know that such brokers’ understanding goes way beyond their own advisors’ pay grade.

Why not train their own advisors to deal with umbrella contractor payslips? To be honest, for the volume of umbrella contractor mortgage applications? It’s just not worth training all their advisors on what is still a niche industry.

Underwriters would much rather let the specialist broker go through a predetermined checklist. Then the broker can present them with a figure they can use in their calculations.

So, yes: it's great that you’re a contractor and you have a payslip. But don't expect that document to open a magic door. In truth, unless you go through a broker, it will close more doors than it shuts.

So how can you overcome these issues?

The key is to first find a mortgage specialist who:

  1. understands your fundamental workings;
  2. knows how to package your application based on your contract rate;
  3. has the knowledge of the marketplace to match all that to the right lender.

Without that applied acumen, lenders struggle to classify umbrella company earnings for affordability purposes.

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.

Posted by John Yerou

on April 9th, 2015 15:35pm in Contracting Matters Blog.