Contractor finance: essential knowhow for all professional contractors
Contractor finances: you can't live with 'em, can't live without 'em. As a contractor, your accounts are apt to squat in your head-space long after you shutdown your laptop.
But you shouldn't let the financial side of running a business run your life. Specialist contractor accountants exist to pick up that slack for you. That said, it doesn't hurt to know the basics of contractor accounts. So, here's what we've got for you:
Table of Contents
- Why bother with tax-planning?
- The benefits of hiring a specialist contractor accountant;
- IR35 and Tax Law: a headache waiting to happen;
- Logging Time and Getting Paid;
- Income Tax and Relief;
- Holidays and Sickness: Consequences and Cover;
- Mortgages for Contractors;
- Retirement and Pension.
Why bother with tax planning?
The fact is, some people adore working with figures. They live for columns of numbers and fine tuning them to match up on balance sheets. Those people are called accountants and they exist to let you enjoy the fruits of your labour.
What they can offer independent professionals is strategic tax planning. It's at the heart of every successful contractor business. As a limited company director and shareholder, you need such a strategy.
HMRC makes all manner of concessions for small business owners. You are in a position to take advantage of those tax breaks.
Now, I don't want to bog you down with a guide to taxation per se. For one, it would take an accountant specialising in limited company tax to produce. And two, rules and regulations can change so often, we'd be forever updating this guide.
How are you, then, supposed to keep up with all these changes to tax law? Simple: you don't.
You hire an accountant to look after your limited company accounts for you.
The benefits of hiring a specialist contractor accountant
Now, that may seem counter-intuitive. Why earn all that cash just to pay someone to help you keep a hold of it?
The truth is, a specialist accountant can save a contractor much more than their hire fee. They'll do all the keeping up with changes in law for you. They'll also ensure that your books are squeaky clean and IR35 compliant.
And that's the key difference. Unlike generic self-employed accountants, they'll ensure that you claim everything the taxman allows you. But moreover, they'll ensure you claim nothing HMRC doesn't permit.
There's a very real danger for contractors who hire any old accountant. Some fees may seem cheap compared to accountants who specialise in limited company contracting.
But the perils of failing an IR35 investigation are real. Ignorance on your accountant's part may see you worse off than your employed counterparts. And there's more than bragging rights at stake.
IR35 and Tax Law: a headache waiting to happen
As a contractor under HMRC investigation, things could get tough. How much would you 'pick up' from your current contract if you had to work PAYE? You'd pay full income tax. You'd pay NICs, but not only employee's. Your business employs you, so you'd have to pay employer's NICs, too.
Agencies may say that there's no-smoke-without-fire. So, yes: you may incur all those costs if found inside IR35. And to add insult to injury? You may also struggle to secure an extension, renewal or new client if HMRC gets their claws into you.
All that said, there's no harm getting to know the basics. You can use this as a checksheet to perform an acid test on what your chosen accountant claims on your behalf. Let's look at the very basics of contractor accounting to give you a starting point.
Logging time and getting paid
The chances are your contract rate is either an amount per hour or per day. That's whether you contract direct or through an agency.
Whilst you might not work fixed hours per se, your client will have certain expectations. So, if you charge a day rate, your contract should outline what constitutes 'a day'. If you charge by the hour, your client will expect you to work so many hours to fulfil the contract.
Once you've clocked up that time, you'll want paying.
To facilitate payment, you'll need to submit a timesheet confirming the hours you've worked. Both you and your client should sign this document every time.
If you are working through an agency, they'll probably have their own timesheets, too. Even so, it's a good idea to fill in timesheets of your own. If that's not possible, at least copy the agency's timesheets for your own records.
Submit that timesheet and your client or agency will pay you in accordance.
As a self-employed contractor, you'll also want to raise your own invoices. Even though you'll submit a timesheet, you should raise a corresponding invoice.
From an IR35 view, a business invoice will help create distance between you and the client. A timesheet alone may make your relationship look too close.
To help avoid any misunderstanding, your invoice should include:
- your limited company name and logo (if applicable);
- the invoice number and date you raised it;
- payment due date, governed by the contract's payment terms;
- from and to dates that the invoice covers;
- details of the work expedited over the invoice duration;
- your day or hourly rate, extended to an invoice total;
- VAT, if applicable, including VAT number;
- your limited company bank account details.
Even if you only keep a digital record, stay on top of your timesheets and invoices. Think like a business: you may want records for any number of purposes in the future.
Income Tax and Relief
Let's get one thing straight: you as the contractor are culpable for your taxes. That doesn't mean you have to do them all yourself. But even if you hire an accountant or not, you alone are responsible for an accurate self assessment.
As alluded in the introduction, professional contractors often hire an accountant. And with good reason.
Limited company law is dynamic: it changes from one budget to the next. Few amendments ever favour contractors working through a PSC.
Over time, the number of articles that contractors can class as expenditure has dwindled. Subsistence and travel are amongst the latest claimable expenses to bite the dust.
Now, you are an independent professional. You specialise in a skill for which clients and agencies pay good money. As such, you stay ahead of the curve in your specialist field. It gives you the edge. Being clued up ensures demand for your service stays hot. But that takes time and effort, often unpaid, on your part.
To try to ask you to keep on top of the changes to taxation law, too? It's an impossible ask.
The benefits of a contractor accountant
Like you, specialist contractor accountants focus tax law specific to their chosen sector. They take the worry of IR35 off your shoulders by keeping your books compliant. They also make sure you claim all the relief available to you.
Yes, you could look upon accountants as a necessary evil. But, over time, you'll realise that a good one can become one of your best business tools.
So, you carry on: get out there earning and learning. In the meantime, here's what an accountant will consider for you:
- Income Tax, based on a combination of dividends and salary;
- National Insurance (employer's and employee's);
- VAT (if applicable, and at what rate);
- Corporation Tax, including that on any retained profit.
Against that, your accountant has to consider viable expenses. Based on the nature of your contract or business, those expenses could cover:
- Protection cover, insurance and pension contributions;
- Accountancy and legal fees;
- Necessary consumables, such as PCs and laptops, smartphones, tablets, phone bills, broadband, etc.;
- Investments, such as product/knowledge training, networking and marketing;
- Other relief, specifically if you use a home office to provide your service.
That's a lot to take on if you're working a 40-hour week with a ball-breaking commute. When you get home, you don't want to spend hours ploughing through how-to guides and receipts. You want to enjoy the quality time your income deserves.
Preparation for DIY accounting
If you are determined to go it alone, fair play. Get organised early. Even before you clock up your first hour, know what preparing your own accounts involves.
Get yourself a calendar with all the important dates highlighted. Be religious about keeping receipts and updating your accounting software with that data.
Make sure you understand HMRC's website. Bookmark the important pages. Also, be certain that you understand what are and aren't allowable expenses.
Double check allowances, such as tax on dividend drawings and personal allowance. You don't want the taxman to deem you inside IR35. But in the same breath, you don't want to pay them more than you ought.
The last thing you want is a scramble when it's time to submit your self assessment. That goes for contractors who hire an accountant, too. A solid relationship with an accountant is one of the strongest assets you'll ever have.
Holidays and Sickness: Consequences and Cover
As an employee, absenteeism isn't such a big deal. Their employer pays for time off for holidays and a certain amount of illness. Holiday and sick pay are not applicable to contractors.
There are ways contractors can prepare for time off, though. Setting aside 'x' amount of your income as a rainy day fund is one. Taking out insurance cover for sickness is another.
Long- and short-term illness protection
There was a time when cover, even long term sickness cover, didn't work for contractors. But in these enlightened times, insurance companies have got with the program.
Yes, you can set aside some of your income. ISAs, shares and savings accounts will welcome your cash. But how do you gauge how much savings will be enough?
It's rare we think about being unable to work long term, let alone how much savings will cover us. What's more, having income tied up earning next to nothing in interest is a cause for stress in itself.
Cover protection has moved on a lot from the days of Keyman Insurance. In many instances, you can claim contributions as a business expense. With savvy advice, you can even get cover that protects your level of income right up to retirement.
As a contractor, you can take as much time off as you like between contracts. Well, in theory. Having extensive time off can have consequences.
The most obvious point is that while you're not working, you're not earning. But indirect consequences for taking too much time off lay dead ahead.
If you're looking to take out a contractor mortgage, be careful. Think twice before heading off around India on a three month sabbatical.
Many contractor mortgage lenders 'annualise' your contract rate. That means they take what you earn per week and calculate your income over a year.
For this calculation, lenders use either 46 or 48 weeks. One or two use 80% of your 52-week annual income.
If you're not working those hours, you may struggle to get a mortgage that reflects your status.
Yes, the odd lender will allow up to 12 weeks between contracts. But the majority like to see six or eight weeks' break at the most.
The other consequence of taking time off is your ability to renew contracts upon your return. Clients hire contractors to get work done. Many rely on contract extensions with the same contractor.
A history of long breaks between contracts could impair your future employability.
Mortgages for Contractors
Like insurance, mortgages for contractors have come a long way in a short space of time. They had to. Post recession, many thousands lost their employed jobs. They took those skills and offered them on a self-employed basis. Many found professional contracting the best way to deliver their service.
The High Street - a no-go, deadly zone
But even now, contractors face problems with mainstream mortgages lenders. On the High Street, advisors still see independent professionals as self employed.
In-branch staff will ask to see your accounts, contract, history and the colour of your socks. As a contractor, you don't need all of this to get a mortgage.
What you do need is a specialist mortgage broker. They'll have built relationships with underwriters at mortgage lenders' head offices. You need to leverage those relationships.
Yes, more lenders offering contractor mortgages than ever. Despite that, limited company payment structures remain a niche area. That's why we've developed contract-based underwriting.
Contract-based Mortgage Underwriting
Rather than rely on post-tax accounts, contractor mortgages use your contract rate. A lender will 'annualise' your contract rate and base their calculation on that figure.
It's not like that in branch. High Street advisors have the calculation they use for permies and little else. Based on your accounts, all they can place in the 'income' figure is salary. That may include dividend drawings, too.
Even so, we know that contractors' true affordability lie in retained profits. In branch staff cannot use that capital in their mortgage affordability tests.
If you want a mortgage that reflects your income, choose a specialist broker. They'll make sure an underwriter can see your true worth. They'll package your application to get a mortgage offer based on income, not accounts.
Retirement and Pensions
Pensions are one of the last bastions of tax relief for contractors. Paying pension contributions through your limited company has benefits on many levels.
In the short term, pension contributions aren't subject to corporation tax. HMRC also incentivises saving for retirement with tax breaks on pension contributions.
There are limits on the tax free amount you can contribute to your pension pot. Those limits apply to both annual and lifetime contributions. For current allowances, it's always best to check with HMRC's pension-check tools.
Over a longer term, your pension will help you live the dream once you retire.
The minute you hang up your contracting boots, you can draw down a tax free lump sum. At time of writing, 55 is the earliest you can retire and 25% the most you can draw down tax free.
With the balance, you can either buy an annuity or draw your pension on an annual basis.
The type of pension you want to invest in will differ from contractor to contractor. Those closer to retirement may want a safer plan. Younger contractors may decide on pension funds with greater risk.
Whatever stage of your career you're at, get solid advice. As with accountants and mortgage brokers, pension specialists exist specifically for contractors.
Starting a contractor business is a big deal. The key is to remember that providing your service and running that business go hand in hand.
The financial side of running a limited company can become overwhelming. If you let it!
It doesn't hurt to know the basics, which we've covered here. But to allow you to live the lifestyle your income deserves, learn to delegate. You don't and shouldn't have to do it all.
Specialist are there at every turn to help you make the most of your contracting exploits. Start by talking to an accountant. Use this guide to see if they have a genuine understanding of contracting. Then, when you're happy, make sure they tell you what they need from you and how often.
Once you've got that in place, the rest of your adventure should be plain sailing. But never be scared to ask for a lifeline if you feel like you're drowning. There's always a specialist on hand, no matter what's rocking the boat.