IR35 And Onshore Employment Rules Push More and More Contractors Towards Umbrella Companies.
For many years now the first decision a contractor had to make when heading out into the contracting sector on their own was to choose which kind of tax vehicle was the most suitable for their purposes. And traditionally most contractors inevitably chose the Limited Company formation. However, as we will see, the ongoing introduction of ever more restrictive tax legislation relating to contractors has made the decision less and less clear cut and in fact, seemingly made the umbrella company more favorable with each new law. And with the arrival of the much-despised IR35 legislation (and more recently the new Onshore and Offshore Employment rules) the umbrella company has quickly become the tax setup of choice for most contractors. That said, the field is still pretty evenly split and new contractors coming to the sector trying to decide whether they should go limited or work via an umbrella are still facing a tough call. This article will attempt to clear up some of the choices involved and ask whether, in light of all the new rules, the Limited Company is still worth it?
Table of Contents
- Limited Companies Offer Control
- Limited Companies Also Require A Lot of Paperwork
- Putting Up That Umbrella
- And Taking It Down Again
- IR35 Turns The Tables
- Are You on the Inside?
- Worst of Both Worlds? Limited Inside IR35
- Are Umbrella Companies The Only Way Forward?
- It’s Not Paranoia If They Really Are Out To Get You
- The Only Way Is Umbrella
Many people go into contracting because they want to break out on their own and have control of their own affairs rather than have to work for someone else. For such people the limited company formation has always been the favoured option because they get to become company directors and own their own company. Of course that’s not the only reason to sign up to a limited company. The other reason is there are, under the right circumstances, significant tax advantages for contractors too. As a limited company director a contractor is entitled to pay themselves in a different way than a permanent employee or an umbrella company contractor. They can pay themselves via a (purposely low) basic salary and then draw the rest of their pay through company dividends. The advantage of these is that they minimise PAYE and National Insurance contributions and therefore save quite a lot of money. Similarly, company directors have a lot more flexibility when it comes to taking their income out of the company and transferring their income to their partner / spouse. They can take advantage of the flat rate VAT scheme and have, as the name suggests limited liability personally.
However, even before the new legislation there were always a number of downsides to limited companies too. The main one and the one which most often leaves contractors disillusioned with limited companies is the sheer amount of administration that is involved in setting up and running them. Most contractors strike out on their own to do the work they love and running a limited company often leaves you bogged down in admin, paperwork, filing and handling accounts (for which the director is ultimately responsible). It is of course possible to get an accountant to handle most of this but this is just another cost (on top of filing fees, legal and admin costs) and you will still have to do a lot yourself. Also, a limited company is more permanent, (simply by the nature of all the time and effort it takes to set it up and then close it again) which means it will not be the right solution for people who are just starting out in contracting and might not know if they will be doing it temporarily or for a long time.
This of course, is where the umbrella came in. Contractors started to use umbrella companies for a number of reasons but the main one was to escape all of the day to day admin and paperwork that came with running a limited company. and to quickly and easily settle into a simple way to contract. Umbrella companies offer the perfect solution for contractors who are just starting out and who aren’t 100% sure they will be contracting for the long term and who might be on lesser rates at the beginning of their career. They allow contractors to be up and running straight away with no papers to fill out and submit to HMRC or Companies House. And best of all, once they are signed on with the umbrella company the contractor gets to concentrate on finding work and fulfilling contracts, without having to concern themselves with invoicing, payment chasing and payroll processing – all of which is handled by the umbrella company.
Of course for a long time the tax benefits of limited companies did outweigh those of the umbrella company, particularly for contractors on very high rates. Contractors who were certain they would be contracting for the rest of their careers and who had reached a very high income were much better suited working under limited liability. And contractors who worked for umbrella companies would have PAYE and NIC’s deducted from their salary week in, week out without fail and without any extra advantages or tax benefits. Moreover, contractors in limited companies would point out that umbrella company employees do have less control over their own affairs.
For many contractors everything changed in April 2000 however when the new regulations were brought in to prevent contractors from being employed as what was described as ‘disguised permanent employees.’ This term referred to contractors who were somehow benefiting from all the usual taxation advantages that come with working for yourself as a contractor but who were nevertheless all but working as an employee for one company – thereby avoiding PAYE and NIC. As an example, a worker (employee) might work for his company up until Friday night, resign and then return on Monday morning (to the same company and office) as a contractor to do exactly the same job, working exactly the same hours. The only thing that would have changed would be that the employee was now doing the same work through their own limited company. This was why HMRC felt it necessary to introduce the IR35 legislation.
After April 2000 then, HMRC had the power to examine a contractor’s working practices, clients and contracts to decide if they fell under the IR35 legislation or not. If they did then there would be serious financial consequences for that contractor. HMRC could now look at a contract and ask if the contractor had the same responsibilities, control and benefits as a permanent employee. Though not a comprehensive list, the following are important factors in making a judgement as to IR35 status:
Control– Is the contractor free to work under their own control and therefore not managed by their client?
Financial Risk – In owner managed companies the owner will risk financial loss in a number of ways, whether through the failure of a client to pay or through the purchase of their own assets such as equipment for the contract, PC’s, laptops, printers, servers and general office equipment.
Provision of Equipment – Will the contractor be using their own equipment rather than that of the company? (Allowances are made from time to time on this one, for example where security measure prohibit the contractor from using their own laptop.)
Substitution – HMRC will check whether a contract has a clause regarding whether someone other than the main contractor can perform the task that the company has been contracted to fulfil.
Employee Benefits – Of course there can be no employee benefits for contractors in limited companies. If you’re getting sick pay, holiday pay, training courses, pension contributions or even an invite to the company Christmas dinner then you will likely be inside IR35!
Right of Dismissal – If there is a fixed notice period between you and the company you are working for then HMRC will see that as treating you like an employee. Instead there should be a provision in the contract for immediate termination if the client so wishes.
If HMRC decide to investigate a contractor for IR35 abuses they will not be looking at just one of these categories, but all of them (and many more) to draw an overall picture of whether you are a legitimate contractor or whether you are more like an employee of a client.
Some limited company contractors will point out that it is possible to work inside IR35 through a limited company and leave other contracts outside of IR35. This is getting into very complex areas of tax management however and would mean that you essentially lose any tax advantages of being in a limited company. The same limited company contractors would nevertheless rightly point out that the following benefits are still in place when working inside IR35: Contractors can still increase their take home pay slightly via the Flat Rate VAT scheme (up to £2000 per year), they only have to pay tax on 95% of their income for the year thanks to a 5% allowance which the government put in place to help with the costs of running a business, they can claim accommodation and traveling expenses as well as taking advantage of employer schemes such as cycle to work schemes, home expenses, annual party allowance and childcare vouchers and can receive interest on any funds held within their company. They will also point out that just because one contract is inside IR35 doesn’t mean all contracts running at the same time or after will be caught too. However, the simple fact remains that if you have a limited company and are caught in IR35 then you will basically be losing the main benefit (the advantageous tax position) but still be keeping all the downsides (via the admin and paperwork). Indeed, if you are caught by IR35 that paperwork and admin will almost certainly be increasing massively.
If you are concerned about IR35 then yes, they are. If you work through an umbrella company then IR35 is simply not an issue and never will be. The section above outlines how people contracting their services through an intermediary (ie their limited company) can face significant financial consequences if caught by IR35 legislation and can make limited companies more hassle than their worth. Umbrella companies do that from the outset – they take away the hassles of a limited company and insulate contractors from the whims of HMRC when it comes to IR35. Ever since the Managed Service Company Legislation of 2007 PAYE umbrella companies have been the one assured safe haven from IR35 and with hundreds of thousands of contractors joining them (moving over from limited companies and the old MSC’s or Employee Benefit Trusts) they quickly became the one sure HMRC approved route for contractors. That’s because no matter who you are contracting for, if you are doing your work through a PAYE umbrella then you are classed as an employee of that umbrella company and already paying the correct NIC’s and PAYE whilst taking advantage of all the expenses discounts and admin services that the umbrella company offers.
In other words, if you were already weighing up the benefits of limited and umbrella company structures and there is any chance whatsoever that now or in the future any of your contracts might attract unwanted IR35 attention, then umbrella companies become more and more appealing. This is especially true when one considers the most recent legislation in this area, the Onshore Employment Intermediaries Legislation.
As if IR35 wasn’t enough, HMRC is continually bringing in new legislation targeted at contractors. The Onshore Employment Intermediaries Legislation (false employment) was introduced in April 2014 and was aimed at recruitment agencies who hire self-employed traders (who are in reality employees) and places responsibility with the agency for PAYE and NIC’s being deducted from gross pay. The agency now has to look at each contractor and use tests of supervision, control and direction to establish if the contractor is taking part in false employment. Though this is aimed mostly at the agencies, it of course affects contractors themselves. Umbrella company contractors are not affected but limited company contractors could find themselves in trouble. Thankfully at the moment a technicality in the law prevents that from happening: limited company contractors who pay themselves via high dividends and low salary would in all likelihood not be affected because the rules note that “if remuneration receivable under or in consequence of the agency contract is not otherwise already treated as employment income” then their agency will have to take off the NIC’s and PAYE tax. However, those limited company contractors who are paying themselves via dividends would likely be ok because a dividend doesn’t count as remuneration in the current legislation. Nevertheless, it could only be a matter of time before HMRC tighten these rules even further and limited companies become even less viable. One only has to look at the supplementary TAAR legislation to see how hard they are going at this and realise that pretty soon there will be no wiggle room whatsoever left.
In the end it is easy to see why so many people are signing up to umbrella companies. Forget that they offer similar take home pay rates for most contractors or that they mean you wont ever have to do a jot of paperwork or admin. Forget that you can claim expenses and that you can be up and running instantly (and leave just as quickly). Just think about one thing – what happens if HMRC sets their sights on you and your business? With an umbrella company you are already paying PAYE and NIC’s which means there is nothing for them to come after you for, be it IR35 or Onshore Intermediaries Legislation. With an umbrella company you’re safe, earning well and hassle free. Can limited companies offer the same security?