Our Knowledge Centre

This section of our website provides essential information specific to contractor clients. We would strongly advise that you review Our Knowledge Centre.

The first decision you need to make is to choose the entity you are going to use to contract through. Some common options are:

  • Limited company
  • Sole trader
  • Agency employee
  • Umbrella company

Limited company

This is the most common, and generally most financially beneficial, option.

You become a director and shareholder of your own limited company.

This option gives you the most scope for financial planning so as to maximise your net income from your contracting activities.

Almost all of our contractor clients operate through a Limited company.

Sole trader

If you are contracting through an employment agency then it is unlikely that the agency will allow you to operate on a sole trader basis i.e. they will insist that you operate through a limited company.

If, however, you are dealing directly with the end-user then in some cases it may be beneficial for you to operate as a sole trader.

In general terms this may be if you have a low contract value and/or if you may only be contracting for the short term.

GRANTS do, of course, provide accountancy services to sole traders so please visit the general practice area of our website for more information.

Agency employee

In some cases you may wish to simply be an employee of an agency. Perhaps this may be a good option if you are simply inbetween jobs and have no inclination to make freelance contracting your career.

As an agency employee you will receive all your income by way of salary and have little scope for reclaiming any expenses.

Umbrella company

This option would necessitate you becoming an employee of a third party company (often known as an ‘Umbrella Company’).

You would effectively work for the umbrella company who would invoice the agency on your behalf. The umbrella company would then deduct a management fee and generally will pay the balance of monies to you as salary.

Umbrella companies have become less popular in recent years as a result of HM Revenue & Customs clamping down on the level of tax-free expenses, which can be paid to its employees.

This option may again be useful for individuals who are only interested in freelance contracting for a short time.

There are various factors to be considered as part of the company set-up process.

Choosing a company name

You are entitled to choose almost any name you like for your company as long as this has not already been registered with Companies House.  However, care should be taken not to choose a name that may be objected to by a company already in business because it is too similar.

Directors

By law, a limited company must have at least one director.

You should decide who is going to be appointed a company director. It is likely that the main fee earner for the company would be appointed a director but you have options in terms of appointing others as you see fit.

Some of the main responsibilities of a company director are:

  • try to make the company a success, using your skills, experience and judgement
  • make decisions for the benefit of the company, not yourself
  • ensuring that the company maintains proper accounting records
  • ensuring the company accounts represent a true and fair view
  • ensuring that accounts and tax returns are submitted to the appropriate authorities
Depending on the service you choose to receive from GRANTS, we will be able to assist you with some of the above responsibilities.

Company secretary

Having a company secretary is not compulsory, but our advice would be to appoint one at the time of setting up your limited company.

The normal scenario is to appoint the spouse of the director as the company secretary but the role could also be filled by a partner or a relative or friend.

Appointing a company secretary means that there is more than one person available in the company to sign or authorise documents and, from experience, we have found this to be very valuable when the director is, for example, working away from home when a tax filing deadline is approaching.

Being appointed a company secretary will have no effect on an individuals financial position unless they receive payment from the company for the duties performed.

Registered office

Normally, the company's registered office will be your home address.  However, in certain cirumstances, this may not be suitable or even permitted.

For example, if you set up a Scottish company whilst living in Scotland but subsequently moved to England, Companies House would not permit your Scottish registered company to change to an English address.  You would have to retain a Scottish registered office address.

Shareholdings

On incorporation, the company will need to have at least one share.  It is likely, at least initially, that this share will be issued to the director of the company to expedite the company set-up process.

Thereafter, it is important to review the share structure of the company with a view to arranging this in the most tax efficient manner.  In some cases, this may involve introducing your spouse as a shareholder.

One final point is that we always recommend that each individual shareholder makes separate payments for their shares.

We normally recommend placing a low value on the shares, e.g. £1.

 

IR35 came into effect on 6th April 2000 to try and distinguish between “disguised employees” and genuine contracting companies. The government of the day were concerned about the hiring of individuals through their own service companies so that they could exploit tax advantages offered by a corporate structure.

Why does IR35 matter to me?

The main reason why IR35 is so important is due to the impact it has on the tax treatment of your contracting income.  If the company is ‘caught’ by IR35, a significant percentage of the contracting income earned is taxed on the worker (normally the director) as a salary.  This gives rise to additional tax and national insurance liabilities.

To put this into some sort of financial context, for a contractor earning £80,000 per year, they could, in some cases, pay additional tax and national insurance of approximately £10,000 as a result of having to apply the IR35 legislation to their contract income.

Who is caught by IR35?

Essentially if your role displays similar characteristics to that of a permanent employee rather than a self-employed consultant, then it is possible that HMRC would seek to class you as being subject to the IR35 leglislation.

How do I stay outside of IR35?

You should be able to demonstrate that you are in business in your own right and show you are genuinely self-employed.

Some key factors to assist with this are:

  • Control – exercise control over tasks undertaken/hours worked etc
  • Mutuality of obligation – if your customer offers work you should not be obliged to accept it as a matter of course
  • Equipment – provide your own equipment where possible
  • Substitution – provide a substitute if you are unable to attend a job
  • Financial risk – bear financial risk for the work you are carrying out
Most of the above are likely to be detailed in your contract, but it’s also vitally important to apply these factors as part of your working practices.  Think and act as self-employed and not as an employee.

Can I obtain an expert opinion on my IR35 status?

Yes, you can have your contract reviewed by an IR35 specialist.  We work closely with specialists Abbey Tax and can provide you with the necessary contact details.

Can I obtain more information on IR35?

Yes.  Please visit our fact sheet for more detailed guidance.

From a financial point of view, one of the most important considerations you have to make is how much money you should draw from the company by way of salary.

In general, dividends are more tax efficient than salary, as there is no national insurance charge on dividends.

So, how do you decide on the level of salary to be drawn from the company?

First of all you should be aware that there is no prescribed rule or formula to assist in setting salary levels – it is the individual directors responsibility to decide on what level of salary to draw from the company.

However the following notes should assist you in this decision-making:

National insurance contributions

Most individuals will wish to maintain their national insurance contributions for State pension and benefits purposes.

The link between national insurance contributions and benefits is very complicated however to maintain the minimum level of contributions you need to take a salary in excess of the relevant earnings limit.

Your monthly cash requirement

Many individuals decide to set a salary, which will provide them with a monthly net pay sufficient to fulfil their monthly financial obligations.

Although there is nothing wrong with this strategy, it may not be the most tax efficient method of extracting funds from your company.

We would, therefore, advise discussing this with us.

IR35 Status

Clearly if you take a very small salary and take the majority of the funds out of your company by dividend then there is more tax at stake and could, therefore, increase the risk of an IR35 enquiry from HMRC.

Therefore, consideration should be give to your IR35 status when deciding on a salary level.

National Minimum Wage Regulations

At present, this will not be a problem for most individuals since providing you are a director of the company and you do not have an explicit employment contract then the Minimum Wage Regulations will not apply to you.

Overview

Dividends are a way of returning the profits made by a company to its shareholders.  However, care must be taken to ensure the dividends declared are ‘legal’.

Some of our clients have moved to us from other accountants and it is clear that many other accountants do not provide contractors with sufficient guidance and advice to ensure that dividends are dealt with in the correct manner.

We place a lot of emphasis on ensuring our clients do indeed deal with dividends properly so as to minimise any exposure in the event of an HMRC enquiry.

How to ensure dividends are legal

  1. You must ensure that the company has sufficient reserves out of which to pay the intended dividend.

    This means it would be preferable to have some financial information as backup to support the dividend calculation.

    The most appropriate back up would certainly be a company profit and loss account. However, if this is not available then we would recommend that you at least prepare some kind of financial workings to justify the company having sufficient reserves to pay the dividends.

  2. Dividends should be paid out of retained profits after taking account of all liabilities, including corporation tax.

  3. You should draw up minutes of a board meeting to declare the dividend, after due consideration of the financial position of the company.

  4. A dividend voucher should be issued to each shareholder showing: the date the dividend is declared, the amount of dividend per share, the total dividend.

Paying dividends

Once you are satisfied that the intended dividend is legal and you have completed the relevant paperwork, the company can then go ahead and physically pay the dividend to the shareholders.

The dividend should be split according to the share structure of the company and separate payments should be made to each shareholder.

It is vital that dividend payments are made to individual shareholders in the correct proportions.

Tax Treatment

All taxpayers receive a dividend allowance of £2,000 each tax year.  If your dividend income does not exceed this amount, there will be no tax to pay on the dividends you receive.  If your dividend income exceeds £2,000 in the tax year then:

Dividends received when you are a basic rate taxpayer will attract a tax charge of 7.5%.

Dividends received when you are a higher rate taxpayer will attract a tax charge of 32.5%.

Dividends received when you are an additional rate taxpayer will attract a tax charge of 38.1%.

Any tax due on dividend income will be due for payment on 31st January following the end of the relevant tax year.

Dividends v Salary

The main advantage to dividends over salary is that dividends do not attract a charge to national insurance.

Also, even where higher rate tax is due on dividend income the tax charge will be lower than the higher rate tax charged on salary payments.

These advantages make the payment of dividends highly tax efficient.

There are various expenses that can be claimed through your limited company to minimise your company's tax liabilities and, therefore, maximise your net income from your company.

Expenses that are incurred 'wholly and exclusively' for the purposes of your business are generally allowable through the company accounts.

All expenditure should be receipted and you should always keep the receipts along with your company books and records.

We have provided details of some common expenses below:

Travel and subsistence covers things such as: travel expenses, mileage allowance, accommodation, subsistence costs and overnight incidental expenses.

There are some special rules concerning travel expenses and we have covered these in more detail here.

As well as the salary paid to the company director, salaries paid to other employees including the company secretary can also qualify for tax relief.

The most important thing for this to be the case is that the salaries paid must be reasonable in terms of the duties the employee/secretary is performing for the company.

Contributions made by your company to an executive pension scheme are allowable deductions for your company.

Also, in certain circumstances, the company can pay a contribution to your own pension scheme and this will still qualify for tax relief.

If the contract is between the provider and your company, up to 100% of the costs will be an allowable expense.

The rules are more relaxed with regards to mobile phones and as long as the contract is between your limited company and the phone provider, the full costs of the contract will be an allowable deduction for your company.

Fees and subscriptions paid to professional bodies are tax deductible as long as they appear on HM Revenue & Customs list of allowable subscriptions.

If you carry out substantive duties from home, it may be possible to claim a deduction for use of your home as an office.

However, HMRC have tightened up their rules and it is proving more difficult to be able to justify a significant deduction without various paperwork being completed.

You can however, claim a round-sum of £4 per week from the company without having to back this up.

Annual parties at Christmas or alternative functions of a similar nature, such as an annual dinner dance, which cost no more than £150 per head can be claimed as a tax deduction. In these cases, it is important that your company arranges and pays directly for the function.

It is often the case that contracts insist on your company having certain insurances in place, normally professional indemnity and public liability insurance. The cost of these premiums will qualify for tax relief through your company.

Although you can use company funds to entertain business acquaintances, these costs will be disallowed as part of the tax return process to deny any tax relief.

Using company funds is, however, still a beneficial way of entertaining as although the company doesn’t receive tax relief, paying through the company is still preferable to paying the entertaining costs personally from your after tax income.

Not only are deductions available for new equipment purchased by the company, it is also possible to claim a deduction for equipment already owned personally at the time the company starts trading.

You should value any equipment that you own personally which the company could use in its trade, e.g. a laptop. You could then sell this to the company and this purchase would then qualify for tax relief.

This type of insurance protects you in the event of you being unable to work through illness.

As long as the policy is set up in the name of your limited company, and the company would receive the payout in the event of a claim, then the premiums are fully deductible for corporation tax.

The following expenses can also qualify as a deduction for your company:

  • Accountancy fees
  • Printing, postage and stationery
  • Computer software & consumables
  • Technical books and journals
  • Training
  • Company bank charges & interest

Registration requirements

It is not compulsory for your company to register for VAT until your turnover exceeds the VAT threshold.

However, you should consider if registering for VAT at an earlier stage may actually be beneficial for you. 

It is likely to be beneficial for most contractors to register for VAT from day one.

Standard VAT accounting

The standard method for accounting for VAT is to deduct the VAT you suffer on expenditure from the VAT you charge in the relevant period and pay the difference over to HM Revenue & Customs.

This method is good if you have a high level of expenditure that you suffer VAT on as you are able to effectively reclaim this from HMRC.

Flat rate scheme

A VAT scheme worth considering for contractors is the flat rate scheme.

The advantages of this scheme as compared with standard VAT accounting are as follows:

  • A financial profit can be made by operating the scheme (in year one) 
  • The scheme is simpler to administer                       

The scheme works by applying a flat rate percentage to gross (VAT inclusive) sales income.  The figure calculated is then entered on your quarterly vat return and paid to HMRC.

Clearly this is a much simpler method of accounting for vat as opposed to having to analyse out all relevant company expenditure to calculate input VAT suffered on payments you have made.

In general terms, most contractors will be classed as 'limited cost traders', so will have to use the flat rate of 16.5%.

At the present time there is also a 1% reduction in the flat rate, which you can use for the first year of your VAT registration, meaning your revised rate for year one is 15.5%.

Although generally you are not able to reclaim any input VAT there is a specific rule, which allows you to reclaim input VAT when you purchase capital goods (e.g. computer equipment) in excess of £2,000 (VAT inclusive amount) in one single transaction.

Below is an example of the potential savings in year one for an IT contractor:

 

£

Net turnover

80,000

VAT @ 20%

16,000

Gross turnover

96,000

 

 

Flat rate VAT @ 15.5%

14,880

 

 

VAT flat rate savings

1,120

The saving is almost completely wiped out in year two when the flat rate reverts back to 16.5%.  At this point, a decision would be made to either continue on the flat rate scheme or move to the standard accounting method for VAT, based on your individual circumstances.

Eligibility for joining the flat rate scheme

This is open to all businesses providing you do not expect your turnover to exceed relevant thresholds.  Currently this threshold is £150,000 therefore if you expect your turnover in the next year to be higher than this figure then you will not be able to participate in the Flat Rate Scheme.

Methods of accounting for VAT

You can either account for VAT on an “invoice basis” or a “cash basis”.

Invoice basis means you will account for VAT according to the date you raise your sales invoices.

Cash basis means you will account for VAT according to the date you receive the money.

The cash basis allows you to defer the payment of VAT and is therefore the preferable method to be used.

The process

Once you have made the decision to stop contracting, it is likely that you will want to close down your company and have this removed from the Companies House register.

There are various compliance matters that need to be attended to and please refer to our closing down service for more information on the actions required.

Probably the most important part of the closing down process is to consider the most tax efficient method of distributing the profits of the company that have been retained when the company ceases to trade.

Generally, there are two methods for distributing these profits:

  • Dividend distribution
  • Capital distribution

The main difference between each method is that a dividend distribution is taxed as income at the usual income tax rates whereas a capital distribution is charged to capital gains tax, usually at a more favourable rate.

Entrepreneurs relief

This relief applies where the final profits are paid out as a capital distribution and allows for an effective capital gains tax rate of only 10%.

For entrepreneurs relief to apply, the following conditions must be met for one year prior to the company ceasing to trade:

  • The company must have been trading i.e. you must have been contracting
  • You must own at least 5% of the company shares
  • You must be an officer or employee of the company

Capital distribution rules

In terms of the normal closing down process, there is a limit on the amount that can be paid out as a capital distribution to shareholders.  At the present time this limit is £25,000 (in total, not per shareholder).

Many contractors, especially those who have traded for a long number of years, will have built up reserves substantially in excess of this figure and would therefore benefit financially by paying out a higher figure than this limit as a capital distribution.

In such cases we recommend our clients to use a route, which is called Members Voluntary Liquidation (MVL).  This would allow capital distributions to be paid out – with no limit.

How does an MVL work?

The company would pay all its liabilities and would carry out all the procedures which form part of the normal closing down process i.e. submission of final accounts to the authorities and all relevant de-registrations.

Thereafter a liquidator would be appointed and the company would enter into a Members Voluntary Liquidation.  It should be noted that this type of liquidation is not the same as company liquidations commonly in the news where companies effectively “go bust” and are unable to pay all their debts.

The MVL process is a legal process and the liquidator will take care of all necessary formalities.  The liquidator will deduct fees and outlays and the balance of funds in the company will be paid out to the shareholders as capital distribution – normally attracting a tax rate of only 10%.

The MVL route is a very tax efficient method of withdrawing funds on the cessation of your company – the higher the closing reserves then the greater savings that can be made!

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