Umbrella, Limited Company or Agency Payroll? - Choosing the right trading structure for your business…

Following the introduction of the IR35 legislation, there are now only three real options open to contractors, so let’s have a look at each option in more detail.

The options available to contractors are as follows:

Option 1 - Umbrella Company (Payroll service)

An umbrella company is essentially an invoicing vehicle for contractors who want to avoid the administration duties normally associated with contracting, namely issuing invoices, chasing payments from clients / agencies, calculating tax and national insurance (NI) contributions and making payments to their bank account. It’s worth noting that because you are employed by the umbrella company, IR35 legislation does not apply.

Contractors who work through an umbrella service will submit timesheets and expenses (normally online) and then leave the rest up to the umbrella company. They will generate and send an invoice to the agency or client, chase payment when it’s due and then upon receipt of payment will calculate your tax and N.I and transfer your net pay direct to your bank account.

Umbrella Company Providers

Naturally, there is a fee for providing an umbrella service which can vary hugely between different companies.

For new contractors the umbrella company is often an appealing option, as it provides an easy and cheap way to decide if contracting is for you.

Many contractors, especially those who are contracting long term or want the best possible return normally decide to start their own limited company, which we will move onto now .

Option 2 - Limited Company (or Personal Service Company)

The vast majority of contractors work through their own limited company, as this is the most tax efficient method, enabling them to keep more of their income. However, these tax advantages are wholly dependant on whether they fall inside or outside IR35 "rules".

What is IR35?

The IR35 legislation effectively seeks to determine what the relationship would be if you were engaged directly by the End Client; in short it asks the question - are you an employee "disguised" behind your limited company?"

Contractors who fall outside the IR35 rules (i.e. not caught by IR35 legislation) will often be better off operating through a limited company, whereas those inside IR35 will often be better with an Umbrella company, as all income will be subject to tax and national insurance.

Provided your contract falls outside IR35 (i.e. you're not deemed to be an employee of the client using a limited company as a disguise) you may draw dividends from the company that are not subject to National Insurance (NI) contributions.

Many contractors decide against starting a limited company because of the day to day administration and the legal requirements all limited companies have to comply with. However, numerous specialist accountancy practices now offer services to contractors to remove many of these headaches (i.e. VAT returns, monthly payroll, annual company accounts, company formation and corporation tax returns).

Option 3 - PAYE through an agency (agency payroll)

The last and generally the least favourable option for contractors is the agency payroll route. In short, you are employed by the agency so you pay full tax and national insurance contributions and you are either tied to working through that agency indefinitely or having to resign and join a new payroll scheme each time you change agency.

In summary, the choice of which trading structure to use is a personal decision which largely depends on the level of return you want to achieve from your contract, but also the amount of administration and legal responsibilities you are happy to incur.