If you are considering how best to run your contracting business, you may have considered setting up a limited company. As of 2023, there are in the region of 4.3 million self-employed workers providing vital skills and services to their customers.
As specialists in UK company formation, we are frequently asked by contractors to advise on the suitability of setting up a limited company. In this article, we will explain the difference between limited and umbrella companies and the advantages and disadvantages of limited companies for contractors. We also discuss how to set up a limited company and considerations such as IR35 and the Managed Service Company (MSC) legislation.
What is a contractor?
Contractors are skilled professionals who provide services to customers for a set amount of time or to complete a specific project. Contractors may be employed directly, through an agency or self-employed. If self-employed, contractors can choose to operate as a sole-trader business or through a limited company.
The difference between a contractor and a permanent employee is that contractors can accept or decline work. Contractors can also negotiate their own terms, fees, and hours of work for each contract. Many businesses prefer to hire contractors to deliver projects because it reduces their overheads (i.e. tax, sickness and holiday pay). And crucially, contracting enables businesses to hire the resources they need without a permanent legal and financial commitment.
Contracting is common in such as IT, the film industry and project management, where there is a defined scope, budget and timescale for delivery.
Limited or umbrella company?
As a contractor, you may be considering using a limited company or an umbrella company. It is important to bear in mind that most medium and large organisations will only engage a contractor if they operate under a limited or umbrella company. By doing so, they can ensure that the contractor is not included in their operational headcount as an employee.
Umbrella companies (e.g. recruitment agencies) normally employ several contractors for temporary assignments. Under this type of arrangement, a contract exists between the client and the umbrella company. The umbrella company then pays the contractor in the same way as an employee through HMRC’s PAYE system. And because contractors enter into a contract of employment with the umbrella company, they typically receive statutory and non-statutory benefits and pensions.
As an alternative to using an umbrella company, many contractors choose to set up their own limited company. A limited company is a type of business structure that is legally distinct from its owners. It is important to weigh up all of the key factors when deciding whether to set up a limited or umbrella company as a contractor. One of the main considerations is whether you fall within or outside of the IR35 rules. IR35 was introduced by the government in April 2000 to prevent “disguised employment”. Disguised employment may occur when a self-employed person sets up a limited company to reduce their tax but is, for all intents and purposes, a permanent employee. As such, if you set up a limited company but fall under IR35, you will still need to pay tax and NI as an employee.
Why set up a limited company as a contractor?
Greater control
One of the main reasons to set up a limited company for your contracting business is that it affords greater control over your affairs. You can decide which contracts you enter into and under what terms. In addition, you also have control over all company matters, including tax planning, drawing dividends, expenses, and pension contributions. If you choose to provide services through an umbrella company, you will not have control over the terms of the contracts or how you pay yourself.
Tax efficiency – corporation tax
Limited companies provide considerable tax advantages. As a shareholder, contractors can pay themselves wages and dividends. By carefully balancing the amount of salary versus dividend paid, it is possible to minimise any tax paid. Dividends are not subject to national insurance, meaning that contractors can keep more of their income. Contractors can also claim more of their business expenses through a limited company. Such expenses may include advertising, business equipment, training, and professional services fees. It is also possible to create different share classes to attract investors or divide ownership between individuals.
Access to the Flat Rate VAT Scheme
Under the HMRC’s flat rate VAT scheme, you can charge VAT at the full rate of 20% but repay HRMC at a lower rate. The limited company can then keep the difference. The amount of VAT your limited company will pay depends on your profession.
Attract more customers
By providing contracted services under a limited company, you will attract more customers – especially medium and large organisations. This is because:
- Limited companies project a more professional image to potential customers
- Customers are more willing to engage contractors with limited companies. This is because of the tax implications if the contractor falls within IR35 legislation and the unlimited liability of sole traders.
Avoids falling under fall under Management Service Company (MSC) legislation
The MSC legislation was first introduced in 2007. The MSC law aimed to prevent corporate structures from being used for the tax benefits of limited companies but without the responsibilities. Prior to the introduction of the MSC legislation, many contractors set themselves up as shareholders in “composite schemes”. Under this type of arrangement, contractors had little day-to-day involvement in the running of a limited company but benefited from the tax advantages of the business structure. It was claimed by HMRC that the use of MSCs meant that contractors avoided paying the full amount of tax and national insurance. As a result, the legislation stopped the use of MSCs if certain conditions were met.
Limited liability
By providing contracting services through a limited company, you will have limited liability if things go wrong. This is because the company is a separate legal entity.
What are the disadvantages of contracting through a limited company?
While there are many reasons to consider setting up a limited company as a contractor, there are some important limitations. Running a limited company entails more in the way of administrative overhead and responsibilities compared to an umbrella company. For example, you will need to draft and submit Annual Accounts and a Confirmation Statement each year. You are also legally responsible for ensuring these are submitted accurately and on time. And remember, this extra administration also comes at a greater cost in terms of accountancy fees and filing fees.
If you only intend to provide contracting services for a short period setting up a limited company may not be the best approach for your needs. This may be the case if, for example, you are contracting between periods of employment. The additional legal and administrative overheads and costs may make a limited company unattractive compared to operating as a sole trader or under an umbrella company.
And finally, if your contracts fall within IR35, the advantages of operating under a limited company are considerably reduced. In this case, it may be preferable to operate under an umbrella company. That said, there are some simple steps you can take to avoid falling within IR35. To do this, you may consider increasing the number of contracts you have, meaning you are not reliant on one customer for your income. It is also advisable to make sure that your contracts are not overly restrictive, e.g. by allowing you to take or refuse work and choose the hours you work.
How to set up a limited company as a contractor
In order to set up a limited company as a contractor, you will need to complete a number of steps, as follows:
- Choose your company name – you will need to adhere to the guidelines provided by Companies House
- Decide your company address, directors, share structure, and shareholding
- Register your new limited company with Companies House – this involves preparing and submitting documents of incorporation, including a Memorandum of Association and Articles of Association.
- Open a bank account for your limited company
- Register for VAT
- Register for PAYE
- Arrange professional indemnity insurance, and
- Keep records of your invoices, expenses, and other financial transactions.
Seven Things to Decide when Setting Up a Limited Company
Final words
Setting up a limited company comes with advantages and some disadvantages for contractors. It is important to weigh up whether operating as a sole trader, under an umbrella company, or through a limited company is preferable, given your plans. If you intend to contract for the long term outside the remit of IR35, setting up a limited company may be suitable for your needs. If you are unsure of the best business structure for your needs, speak to a company formation service provider or an accountant who will be able to advise you based on your unique circumstances and future plans.
Uniwide Formations specialises in all aspects of UK limited company formation and incorporation for contractors. Based on your needs, we will professionally and efficiently handle your company registration and draft your memorandum and articles of association.
