Save tax by using an umbrella company
Umbrella companies provide tax efficient payroll services for contractors. Without an umbrella company’s services a contractor would have to classify himself or herself for tax purposes as simply being self-employed, thereby becoming entirely responsible for their own tax returns. In most cases this leads to the individual paying more tax than is actually necessary.
Before the year 2000 contractors were able to set up a limited company to help reduce their tax burden. Rather than take a full salary that would be subject to income tax, they would receive a minimal salary and take the remainder of their earnings in the form of a company dividend. Company dividends are subject to corporation tax, which is much lower than income tax.
To address this, in April 2000 the UK Government introduced new legislation designed to prevent contractors from exploiting this tax loophole. The legislation is called IR35 and allows the government to levy tax on contractors at the same rate as if the company they are working for directly employed them. The new rules meant that if a contractor worked in the client’s offices and used the client’s infrastructure, they would be considered an employee of that company, rather than being self-employed.
The result of IR35 legislation was that many contractors immediately started earning up to 25% less, as their tax rate rose from around 20% (corporation tax) to 40% (earning’s rate). The highest paid contractors would also be taxed at the additional rate of 50% for all earnings over £150,000 per year.
To combat this trend some contractors utilized umbrella companies. These companies were set up to provide easy ways to save tax legally. This is achieved by deducting all allowable expenses prior to taxation assessment. Usually the largest expense is travel, although there are some other dispensations, such as subsistence, overnight expenses, and subscriptions to professional bodies, equipment, training and pensions.
The advantages of using an umbrella company
The main advantage to a contractor of using an umbrella company is that it dramatically reduces his/her administrative paperwork, freeing up valuable time that can be used to generate further income. Umbrella companies usually charge a fixed monthly fee that is, on average, lower than the fee charged by an accountant. As well as the tax advantages, an umbrella company acts as a permanent employer. This can help with securing personal loans and mortgages, as many banks are more willing to lend to those who are employed by a business rather than being self-employed.
As far as the contractor is concerned using an umbrella company is very easy. A contractor simply sends a time sheet and receipts of expenses to the umbrella company each month. The umbrella company then sends an invoice to the client (i.e. the company the contractor is working for on behalf of the umbrella company). On receipt of payment from the client the umbrella company deducts business expenses, thus reducing the taxable income for the contractor. The contractor is paid through the PAYE system (Pay As You Earn), which deducts tax and national insurance. The rules regarding dispensations are often updated by the HMRC and a good umbrella company will ensure that their contractors are always taking maximum advantage without breaching the rules.
Since the introduction of IR35 umbrella companies have provided contractors with the easiest, safest and most efficient way to manage their tax affairs.