Why set up your own limited company?
For all but a small minority of contractors, operating your business through your own limited company is by far the best solution. It allows you to have complete control over the financial affairs of your business whilst being the most tax efficient trading option, so you maximise your income. As the majority of contractors are motivated to leave permanent employment to increase their earnings, the limited company is generally the most attractive.
Some of the benefits of contracting through a limited company include;
Control of your business’s financial affairs/bank account
By being a director and shareholder of your own business, you have complete control over the running of your company and its bank account/financial affairs.
- National insurance savings
By setting up a limited company, you become a shareholder in the company and are legally entitled to pay yourself a distribution of the profit from the company. This payment is known as a dividend which does not attract national insurance, meaning you can retain more of your contracting income.
- Wider range of expenses claimable
Operating through your own limited company gives you the ability to claim back a wider range of expenses (eg accountancy fees, training, equipment & software costs)
- Access to the Flat Rate VAT Scheme
The flat rate VAT scheme is an incentive provided by the Government to small businesses to help simplify taxes. You charge VAT on your invoices at the prevailing rate (20%) but pay it back to HMRC at a lower rate, and your business gets to keep the difference! VAT rates differ depending on your profession/trade but for IT contractors the rate is 13.5% in your first year (1% discount applied for first year of trading) and 14.5% in subsequent years.
Please note that these tax efficiencies are subject to your contract falling outside of IR35 legislation. Most contracts we see do fall outside of IR35, please see the section on IR35 Legislation below for more information.
Which Contractors should not use a Limited Company?
If you are only intending to be a contractor for a short period of time i.e., just a few months between permanent employers, setting up your own limited company would not be the best option for you because of the costs and administration involved in setting up and closing a company.
Likewise, if you’re new to contracting and not entirely sure if you’re in it for the long term, then a limited company probably isn’t a good idea initially. However, if you then decide to stick with contracting, you’d almost certainly be better off switching to a limited company.
If you see yourself in either of the scenarios above, you’d probably be better off using an umbrella company initially (see Umbrella tab) This option allows you to be a PAYE employee, with the umbrella company contracting with your customers and being responsible for invoicing, administration, credit control and paying you a salary, less deductions for income tax and national insurance. You would simply submit your timesheet and expenses to the umbrella company and they would do the rest. However, as explained earlier, you would suffer more income tax and national insurance deductions than you would as a director/shareholder of your own company.
If at a later date you decide that contracting is what you want to do long term then you can always form a limited company at that point, but in the meantime the umbrella company facilitates your one–off short term contract and your desire to test the waters of contracting, without incurring costs or unwanted administration.
Some contractors, whose contracts are caught by IR35, also choose to use the services of an umbrella company because they do not qualify for the tax advantages that make the limited company route so attractive. However, if you feel that you prefer the idea of retaining control over the financial affairs of your business, or may have contracts in the future that will fall outside of IR35, there is no reason why you shouldn’t set up and operate through your own limited company from the outset.
What is IR35 and how will it affect you as a Contractor?
The IR35 Legislation looks at your relationship with your end client and seeks to determine whether you’re truly self-employed or an employee “disguised” behind your limited company.
If you are “outside IR35” (i.e. HMRC see your relationship with the end client as a supplier-customer relationship), then you will benefit from the tax advantages of a Limited Company (See the Tax efficiency section above). Contrary to popular opinion, the vast majority of the contracts that we see are outside IR35.
If you are found to be “inside IR35 (i.e. HMRC see your relationship with the end client as an employee-employer relationship), then much of the tax benefits of operating through a contractor limited company are lost, because your income from the contract will be treated as PAYE and taxed accordingly.
What to do if you’re inside IR35
If you find that your contract falls inside IR35 then, as mentioned above, you may wish to use the services of an umbrella company, particularly if all future contracts are likely to be the same (ie fall inside IR35). However, you can still operate through your own limited company; you won’t have the tax benefits but neither will you be paying the fees of an umbrella company, and you will have complete control over your company’s financial affairs and its bank account.
What to do if you’re outside IR35
Set up a limited company! It is by far the most tax efficient way of operating and as a result the option that will maximise your income. Typical take-home pay for a contractor operating through a limited company is approximately 75-90% compared with 60-65% for those using an umbrella company.
What should you consider before setting up a limited company?
Your responsibilities as a director of your own company
- The Company must be registered at Companies House.
- Your Annual Accounts and Annual Return must be filed at Companies House each year.
- A Corporation Tax return detailing the Company’s profit must be made to HMRC each year.
- Any resulting Corporation Tax must be paid to HMRC within nine months of the Company year end.
- PAYE must be operated for anyone employed by the Company, and the company must pay any income tax and national insurance due to HMRC each month.
The above responsibilities may seem a little daunting, but many good accountants now offer an all-inclusive accountancy package where all but the most minimal of administrative duties will be taken care of for you.
Your contract – does it fall inside or outside of IR35?
As mentioned above, if your contract falls inside of the IR35 legislation there will be little monetary benefit in operating through your own limited company, particularly if the nature of what you do means that future contracts will also fall inside of IR35. See below for more information about what IR35 is and how it affects contractors.
What expenses can be claimed through a limited company?
There are numerous business expenses that can be legitimately claimed through a Contractor Limited Company including;
Business travel, subsistence and accommodation
Postage and Stationery
Mobile telephone and broadband
Contributions to an executive pension plan
Equipment purchased for business purposes
Motoring mileage allowances
Computer hardware and software
Technical books and journals
Use of home as office
Company bank charges and interest
So, how do I set up a Contractor Limited Company and start contracting through it?
STEP 1 – Form your limited company
Before your business can set up as a limited company (or become “incorporated”) it needs to be registered with Companies House. You will need to complete a number of documents (such as the Memorandum of Association and Articles of Association) and return these to Companies House to complete the incorporation process. These documents are normally prepared by an accountant to ensure everything is completed correctly.
STEP 2 – Open a business bank account
Once you have your limited company formed you will need a business bank account in the name of your company. You can set up a business current account with the bank or building society of your choice.
STEP 3 – Consider your VAT position
As a contractor it may be beneficial for you to be registered for VAT. It may also be advisable for you to register for the Flat Rate VAT scheme. HMRC introduced this scheme to make it easier for small businesses to account for VAT. In short, the scheme means you charge VAT to your client / agency at the standard rate of 20%, but to pay VAT to HMRC at a lower rate depending on your industry, For example, IT contractors pay VAT at 13.5% so it’s definitely worth considering this option. An accountant should be able to advise you on the best course of action given your circumstances.
STEP 4 – Register for PAYE (pay as you earn)
All employees of a Limited Company are subject to PAYE & NI on any salary they receive from their company. The company is therefore obliged to register for PAYE and to account to HMRC each month for the PAYE & National Insurance Contributions that are due.
STEP 5 – Organise Professional Indemnity Insurance
Prior to starting your contracting role you will need to organise professional indemnity insurance, PII, in order to protect yourself from any claims of negligence, loss of data or documents, unintentional breaches of intellectual property or claims of dishonesty. A good level of professional indemnity cover (£1 million or more) will cost you approximately £300-400 per year. Your Agency or Client will insist on seeing proof of cover before signing a contract with your company.
STEP 6 – Invoice your Clients and Keep a Record of Expenses
Once you have everything in place you are then able to start invoicing your client or agency for your contracting work. However, in order that your accountant can prepare annual accounts and quarterly VAT returns you will need to keep a record of all invoices and expenses for the business.
Some accountants will provide a spread sheet template for you to manually keep a record of all invoices and expenses, but these days, specialist providers will provide an online system to simplify these tasks for you.