Umbrella companies are designed to remove nearly all the administration and company management associated with a limited company, which is why they can be a popular choice for some contractors.
The main advantages for using an umbrella company are:
- It means you avoid the hassle of running a limited company
- There is no need to be involved with uploading data to an online solution, completing VAT returns, submitting RTI returns, company accounts, taxation, director’s responsibilities and so on
- For short-term contractors, a main advantage is not having the time consuming process of forming a company and then arranging for it to be dissolved
An umbrella company however does come with the disadvantage in that it is not as tax efficient as using a limited company structure, because via an umbrella you will be taxed as if IR35 applies (or caught by IR35), which can mean a difference of circa 20% in your tax home pay. If you can contract outside IR35, and are a higher rate tax payer then contracting via a limited company is the better financial route to take.
The key differences between umbrella and limited company are are explained in the guide ‘Limited Company or Umbrella: Deciding on a Payment Structure.’
What is an umbrella company?
An umbrella company is in simple terms an outsourcing of your payroll. Rather than having the cost and hassle of setting up your own limited company you can work via an umbrella company.
With an umbrella company solution:
- The contractor would not be a director nor have the responsibilities associated with running a limited company.
- The umbrella company provider would take care of all accountancy and taxation matters and also deal with all administration matters.
- The contractor completes a timesheet and forwards it to the umbrella company, who then invoices the agent.
- Following payment by the agent to the umbrella company, a payment is made by the umbrella company to the contractor.
Since the Managed Service Company Legislation was introduced in the 2007 Budget there is only one viable choice for an umbrella company, which is the PAYE Umbrella.
A PAYE umbrella treats all your income as salary. This means you will pay employers NI, employees NI and PAYE on all your income. It is the need to pay employers NI that results in much higher taxation than if you used a limited company.
Beware: There are other payment schemes which purport to be "compliant umbrella schemes" and offer large take home pay figures of 90%+. Often these are based on loan schemes - these do not work, despite what you may be told. Whilst they may appear to be working on the short term, eventually, and this can take years, HMRC will catch up with you, and you will be liable for unpaid taxes, including interest and penalties. Do not touch them.
IR35 issues with umbrella schemes
Note that any choice of payment structure (umbrella, limited company etc) does not in any way influence the IR35 status of the contract or modus operandi of the working arrangements. The choice would not influence any HMRC review or decision as to whether the contract falls within the regulations of IR35.
However, operating using a PAYE Umbrella means that all your income will be treated as though you are caught by IR35, regardless of the actual IR35 status of each contract. The financial impact of IR35 on contractors is considerable, and long term contractors would be wise to invest time avoiding the legislation. You can find out how much it could effect you using the IR35 Calculator.
Advantages and Disadvantages of umbrella companies
- Avoids time and trouble of running a limited company. After a simple set up, the contractor completes timesheets and forwards to the umbrella company.
- Knowledge that money is lodged into their bank account and documents are sent to them explaining how the payment is calculated. No need to be involved with running a spreadsheet, VAT returns, payroll matters, company accounts, taxation, etc.
- For short term contractors, a main advantage is not having the costly process of forming a company and then arranging for it to be dissolved.
- you are effectively employed, and therefore get some employment rights, like sick pay and holiday pay. The sick pay is statutory sick pay, and the holiday pay will actually be processed by withholding some of your gross fees to then get paid back to you when you take time off. And if you do not take the holiday, it cannot be paid back to you.
- The contractor will by definition not be running the company and will therefore be using it simply as a service to process transactions.
- The contractor cannot represent themselves as running their own independent business, through which they can make policy decisions, take risks or act as company director.
- There is inevitably some delay in the contractor receiving their money, since it needs to pass through a third party account before reaching them. This is down to the efficiency of the umbrella company.
- There is an element of trust on the part of the contractor, since their money will be passing through the third party umbrella company bank account.
- For long term contractors whose contracts are outside IR35 umbrellas are not as tax efficient as using a limited company.
- For contractors caught by the SDC rules, expenses cannot be claimed pre-tax.
Should you use an umbrella or limited company?
For long term contractors outside IR35 the limited company is the recommended route.
For short term contractors and those inside IR35, the choice is similar to owning a car or using a hire car or taxis/bus service. With car ownership, you are fully responsible for the purchase, running costs and eventual sale of the car (just like your own limited company). It works well as a long term solution where you will need the car for a minimum of one year. Compare this with a holiday situation, where you would hire a car or use taxis - much better for a short term solution where you do not want or need the benefits of ownership and do not wish to be concerned with the running costs of the taxi/bus - you just want a simple solution to get you to your destination (just like an umbrella company would do for you).