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Contractor doctor: Do I need to set up a limited company before seeking a contract?

Dear Contractor Doctor,

I’ve finally decided to take the plunge and leave permanent employment for contracting. Just handing in my notice has been a huge relief!

There’s one thing I’m unsure about: Do I need to get a limited company set up before I start looking for a contract?

Thanks

Christian Doherty, London

Contractor Doctor says:

Firstly, well done on finally making the jump. You are unlikely to regret it. Contracting can be very enjoyable and financially rewarding.

Don't panic - there is no immediate rush

You don’t need to rush and decide on a payment structure before you have even started looking for a contract. This decision can actually wait until you have secured your first contract and negotiated the terms and conditions.

Historically it could take weeks to get a payment mechanism in place, particularly for limited companies. But today this can be done in 24 hours using online company set-up facilities and by using business current accounts that can also be set up within minutes.

The 5 step process is as follows:

  1. Look for a contract. Secure an interview and get an offer.
  2. Establish your likely IR35 tax status.
  3. Consider how long you will be contracting.
  4. Consider which option will be best for you.
  5. Make a choice - set up arrangements.

What's best for you? Limited company or umbrella?

The optimum payment structure to use will depend on your IR35 status. If you are inside (caught) by IR35 then a limited company option would not be the best solution. In that instance you should choose a PAYE umbrella company.

Or if you only plan to contract for a short period then setting up and closing down a company isn't a sensible option. Also, for lower earnings a limited company won't offer significant tax breaks so isn't worth the hassle of using.

And lastly, due to legislation changes many umbrella companies will not process contracting expenses, so if you have significant expenses that you want to claim tax free then an umbrella might not be the best choice.

When to use an umbrella company

Use an umbrella company if:

  1. You only plan to contract for the short term - 6 months or less.
  2. You are caught by IR35 and it's likely you always will be.
  3. Your earnings aren't high enough to make significant tax savings by using a limited company.
  4. You do not incur and need to claim many contracting expenses

An umbrella company is basically a payroll company that employs you and processes your earnings as employment income. They will charge for this service, and all deductions will be made to account for national insurance contributions (both employers and employees) and PAYE income tax.

Since the Travel and subsistence legislation came into effect it has made it very hard for contractors to claim expenses when using umbrella companies. So if you have significant expenses and earn above £15 per hour then using a limited company structure would be financially better.

When to use a limited company option

Consider using a limited company if:

  1. You plan to contract for the longer term - more than 12 months.
  2. You are outside of IR35.
  3. Your earnings are high enough whereby tax savings can be made from using a limited company.
  4. You have high earnings, are outside IR35, and have a partner who has little or no income.
  5. You have significant contracting expenses that you need to claim

If you plan on contracting for the long term then a limited company will give you more flexibility and tax advantages should you fall outside of IR35. Your company will be able to retain profits (handy for tax planning), pay expenses to you tax free and also potentially save you significant amounts of tax via good dividend planning.

When to set up your chosen structure

You will need to have your payment structure sorted out by the end of the first week of contracting so that the agency can pay you on production of your timesheet and invoice (see how to prepare one). Or it might be that you invoice monthly (very common) in which case you will have more time. Until then there is no hurry or legal requirement to have something in place.

Once the contract is agreed you can get started by speaking to a specialist accountant who can advise which path is best for you.

Good luck with your contracting.

Contractor Doctor

Updated: Tuesday, October 4, 2016

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