Limited company contractors get a much better take-home pay deal for doing very similar things to employees. And husband and wife or civil partnership teams can enjoy even greater financial benefits. So, what do employees get in exchange for tying themselves to employers, and can the extra tax they pay be justified?
Firstly, let’s compare and contrast three sets of income: an employee, a limited company contractor and a post-contracting husband and wife team. Each has a gross income of £106,150, either as salary, contracting fees or property income.
Employee – Isabella
The employee shoulders the heaviest tax burden, and has the lowest net income of the three scenarios. Personal taxes, made up of income tax and National Insurance Contributions (NICs), account for 37% of gross salary.
| Gross salary | £106,150 |
|---|---|
| PAYE income tax | £33,570 |
| Employee NICs | £5,460 |
| Net income | £67,116 - 63% of gross fees |
As an employee, Isabella also cannot claim any costs of employment, such as commuting costs, office equipment, computers and software or phones and broadband. Plus, if there are any children in the household, this employee has lost child benefit, as there is a single earner earning over £60,000 per year.
Limited company contractor – Edward
Running a one person limited company, contractor Edward enjoys the next most favourable tax regime, paying 32% of gross fee income as corporation tax, income tax and NICs. The contractor’s net income is approximately £500 greater each month than the employee’s, without taking into account business expenses.
| Contracting income | £106,150 |
|---|---|
| Expenses | £11,070 |
| Profit | £95,079 |
| Employers NI | £70 |
| Corporation tax | £19,015 |
| Dividend tax | £11,258 |
| Employees NI | £48 |
| Net income | £72,756 - 68% of gross fees |
In this scenario, the contractor also benefits from tax relief on business expenses, including travel costs and the costs of running a home office. Edward also has much greater control over how much tax he pays, by making use of allowances and pre-tax investments, such as his limited company investing in his personal pension.
Post-contracting husband and wife team – Harry and Amelia
Harry and Amelia represent a very typical scenario. They were both successful contractors earning significantly higher net incomes than if they had been employed. As a result, they built up a tidy property portfolio that in the below table earns them £84,950 in rental income and profits on property sales of £21,200.
| Harry | Amelia | |
|---|---|---|
| Rental income | £42,475 | £42,475 |
| Profits from property sales | £10,600 | £10,600 |
| £53,075 | £53,075 | |
| Combined income | £106,150 | |
| Taxes: | ||
| Personal allowance | £8,105 | £8,105 |
| Taxable income | £34,370 | £34,370 |
| Income tax @ 20% | £6,874 | £6,874 |
| Tax of captial gains | Zero (under CGT limit) | Zero (under CGT limit) |
| Combined taxes | £13,748 | |
| Combined income after taxes | £92,402 | |
| Effective joint tax rate | 12.95% | |
| Comparison with employee | ||
| Employee salary | £106,150 | (equivalent single earner) |
| Employee net income after taxes | £67,119 | (take home pay) |
| Difference | £25,283 | (extra take home cash for Harry and Amelia) |
Because the same level of income is shared across two sets of personal allowances, Harry and Amelia pay an effective tax rate of only 12.95% and enjoy a net income of £92,402. This is £25,283 more than if one of them was employed and earning the same income (that’s about £2,106 extra each month). And the couple are not employing any clever offshore or ‘aggressive’ tax avoidance schemes – they are simply using the same allowances available to any taxpayer in the UK [but note this only works for married/civil partnership couples, due to the settlements legislation].
Plus, if Harry and Amelia have children, they qualify for full child benefit as neither earns over the £50,000 threshold at which the benefit starts to be withdrawn.
Employment vs contracting: the lesson
So, what lessons can we learn from these three scenarios, now that we can see in stark relief how differently the same income can be taxed under the same tax code?
- Being an employee is an increasingly expensive choice. In exchange, employees allegedly receive some degree of security and employment rights. In today’s labour market, job security is arguably minimal, and employee rights are unlikely to ‘protect’ highly skilled knowledge workers. Would you pay over £25,000 in extra tax each year for these dubious benefits?
- Contracting offers workers an opportunity to earn more as well as to enjoy the lifestyle benefits of ‘being your own boss’ and choosing when, where and how to work. It also places much greater control over how a worker’s gross income is directed, which is only possible to a very limited extent for employees
- Splitting an income over two sets of tax allowances quite literally pays dividends. Although the example we used here was of a post-contracting married couple generating income from a property portfolio rather than contracting income, the principle is the same. A married couple can own a limited company with one person earning most of the fees and benefitting from two sets of allowances.
Being employed is just so inflexible and expensive, it’s a wonder anyone still chooses to do it.