Myths and Misunderstandings Surrounding Umbrella Companies.

Despite the fact that working via an umbrella company is now an accepted and popular practice amongst contractors, there are still many people out there in the contracting/freelancing community and beyond who do not understand what umbrella companies are and how they work – or the benefits they can bring. Indeed many contractors still lump umbrella companies along with Managed Service Companies and other intermediaries as part of the group that often gets its’ collar felt by the men at HMRC. In fact, as we shall see, the opposite is true and umbrella companies are fast becoming the default and most secure way for contractors to manage their earnings. This article will look at some of these misunderstandings and misconceptions and explain why it is that umbrella companies have become so popular:

What Exactly Are Umbrella Companies Then?

Essentially umbrella companies are companies that operate with the aim of acting as an intermediary between contractors (and occasionally freelancers) and the clients they are working for. The reason that they do this is so that the umbrella company can offer a service to the contractor – the processing and handling of any and all administration and paperwork that comes the way of the contractor as part of their day to day work activities. Generally this involves the umbrella company handling the contractor’s payroll as well as their taxation (and dealing with HMRC) as well as the issuing of invoices and then chasing up clients for payment thereafter. The idea of such a service is that it frees up the contractor to concentrate on their contracts and earning money, rather than getting bogged down in paperwork.

That All Sounds a Bit Complicated – Is It?

Actually quite the opposite – the reason that umbrella companies have been gaining in popularity is that they make contractors’ lives much easier. No more complicated taxation issues, no more heavy paperwork, no more dealing with Companies House or HMRC. It couldn’t be simpler in fact. Perhaps the best way to highlight this is to show how it would work for a new contractor:

A contractor would join an umbrella company simply by phoning up or sending an email. They would be signed on that same day as an employee of the umbrella company and the umbrella company would be their ‘employers’ with a contract of employment (and all the associated legal rights) between them. That’s it, that’s all that is involved in getting started. Thereafter the contractor would work their contracts as per usual and not have to do any paperwork or calculate any taxes. The only time they would have to do anything at all would be at the end of the week when they would be required to submit a timesheet and an expenses sheet to the umbrella company. And then they can either do more work, or put their feet up and relax. Meanwhile, the umbrella company would be responsible for invoicing clients on behalf of the contractor and would also collect the payments (and pursue payment if there were any problems). The client would then pay the umbrella company who would manage PAYE and NIC’s for the contractor, deducting them (as well as any expenses) before passing on the remainder to their contractor.

That All Sounds Great But Isn’t This A Niche Product, Only Suitable for a Few Contractors?

On the contrary, umbrella companies are becoming the default choice for new contractors and a large number of long-term contractors are moving over from limited companies to umbrella companies. With HMRC cracking down on most other contractor tax vehicles – everything from Employee Benefit Trusts to Managed Service Companies have long since been caught out by HMRC – umbrella companies, alongside limited companies, have become the only game in town. And certainly there are times when a limited company is the better choice for a contractor. Often long term contractors will prefer to keep full control of their own affairs and remain as director of their own company, preferring to do all that paperwork themselves or they will decide that it is advantageous for them to stay limited in order to claim a broader selection of expenses or take advantage of the flat rate VAT scheme. Certainly for contractors earning in excess of £300 a day there are some extra tax advantages that are worth looking at. But for any contractor earning less than that (and for many earning more) the extra hassle of all that admin and paperwork is simply not worth it. For contractors on less than £300 per day the tax advantages are about the same via limited company or umbrella company, but umbrella companies obviously mean no paperwork or admin.

And it is for that reason they are becoming the default choice and no longer a niche product – and why there are now more than 200,000 people in the UK working through them.

Ah, But Won’t This Just Be Another Way for Me To Get Caught By The Taxman – What About IR35?

This question cuts to the heart of why they are becoming so popular (aside from their lack of admin and paperwork and other advantages). Umbrella companies are rock-solid, 100% safe and compliant, particularly when it comes to IR35. As you know, IR35 strikes fear into the heart of most contractors and the prospect of getting investigated (and facing massive bills and fines) is one of the downsides of working through a limited company. A PAYE umbrella company however cannot fall under the IR35 legislation because contractors are paying their PAYE and their National Insurance contributions and therefore not avoiding any tax. It was the same thing with the 2007 Managed Service Legislation, which explicitly noted that umbrella companies would not fall under the legislation. If you want security against that rainy day, get an umbrella!

Ok, So What Other Advantages Are There?

As well as being the most secure and compliant option and freeing up time for you to work (or play) more, just like limited companies, umbrella companies have the potential to maximize your income through expenses. This means that when the contractor works at various different workplaces and locations they are all classed as temporary places of work and the contractor can then offset their travel and subsistence costs. These are costs involved with getting to and from work at the various sites and cover things such as travel, food and drinks and even hotels. All of these in turn allow the contractor to reduce their gross salary and the tax burden they will face. Finally, contractors working through an umbrella company are ‘employed’ and therefore benefit from the full range of employment laws on everything from sick leave and maternity leave to holidays and holiday pay.

Other Companies Are Offering Higher Income Retention Through Paying Less Tax – How Is that Possible?

It isn’t. Because they operate through PAYE all umbrella companies offer the same rates on tax. It is through their use of expenses and the depth of their administrative services (as well as their fees) that you should judge an umbrella company. And if they are not an umbrella company and are offering all of the above – avoid them like the plague unless you want to spend some serious time with HMRC later in the year!