Are you considering your options when it comes to working as a contractor? If so, you may have heard about the differences between a limited company and an umbrella company. In this article, we will explore the differences between Limited company versus umbrella company and the advantages and disadvantages of each option to help you make an informed decision. Whether you are looking for increased flexibility or simplicity in managing your finances, understanding the contrasts between these two structures is crucial. Let’s explore the world of limited companies versus umbrella companies, and discover which one might be the perfect fit for you.
What is a Limited Company?
Definition
A Limited company is a legal entity that is separate from its owners (shareholders) and has its own legal identity. It is formed by registering with Companies House, and once established, it can enter into contracts, own property, and engage in business activities. The company’s liabilities are limited to its assets, and its shareholders are not personally liable for the company’s debts.
Legal Structure
A Limited company is governed by the Companies Act and must comply with various legal requirements, such as holding annual general meetings, filing annual financial statements, and maintaining proper company records. The company is run by its directors, who are responsible for the management and decision-making of the company. Shareholders, on the other hand, have ownership of the company and may receive dividends based on their shareholdings.
Ownership
In a Limited company, ownership is determined by the issuance of shares. Shareholders hold shares in the company, which represent their ownership stake. The shares may be held by individuals, other companies, or even trusts. Shareholders can buy and sell shares, and their ownership can change over time. The shareholders’ rights and privileges are defined in the company’s Articles of Association.
Benefits
Operating as a Limited company can offer a range of benefits. Firstly, the Limited liability nature of a company provides protection to its shareholders’ personal assets. If the company incurs debts or legal issues, the shareholders’ personal assets are generally safeguarded. Additionally, operating as a Limited company can enhance the professional image and credibility of a business, making it more attractive to clients and investors. Furthermore, a company’s profit distribution can provide tax advantages to its shareholders, as dividends are typically taxed at a lower rate than other forms of income.
What is an Umbrella Company?
Definition
An umbrella company is a service provider that acts as an employer to contractors or freelancers who work on a temporary basis. The umbrella company handles the administration, payroll, and tax obligations on behalf of the contractors, allowing them to focus on their work without the responsibilities of running a company. The contractors become employees of the umbrella company and are engaged on a contract basis with their clients.
Legal Structure
An umbrella company operates as a Limited company, typically with a single director who manages the company’s affairs. The company is registered with Companies House and must adhere to the same legal requirements as any other Limited company. However, the legal structure of an umbrella company differs in terms of its engagement with contractors as employees, rather than shareholders.
Ownership
As an umbrella company is a limited company, its ownership is determined by the shares issued. However, unlike a traditional limited company, the ownership of an umbrella company is usually concentrated in the hands of the director or the service provider running the company. Contractors who work through an umbrella company do not have ownership or shares in the company itself.
Benefits
The primary benefit of working through an umbrella company is the ease and convenience it offers to contractors. By becoming an employee of the umbrella company, contractors can avoid the administrative burdens and responsibilities of running their own Limited company. The umbrella company takes care of tasks such as invoicing clients, processing payments, handling tax deductions, and ensuring compliance with employment legislation. It also provides contractors with access to employee benefits such as pension schemes and holiday entitlement.
Tax Considerations
Tax Structure
As a Limited company, the tax structure differs from that of an umbrella company. In a limited company, profits are subject to corporation tax, which is currently set at 19% for companies with profits of less than £50,000, 25% on profits of £250,000 and somewhere in between for companies with profit between £50,000 and £250,000. Shareholders can then receive dividends from the company’s after-tax profits, which are subject to dividend tax. Dividend tax rates vary depending on the individual’s income tax band, with lower rates compared to income tax rates.
In an umbrella company, the contractor’s income is subject to PAYE (Pay As You Earn) tax and National Insurance Contributions (NICs). The umbrella company deducts these taxes and contributions from the contractor’s gross income before paying them their net salary.
Tax Responsibilities
In a Limited company, the company is responsible for maintaining accurate financial records, filing annual accounts, and submitting tax returns to HM Revenue & Customs (HMRC). The directors are responsible for ensuring the company’s compliance with tax laws and regulations. This includes reporting income, claiming allowable expenses, and paying taxes on time.
In an umbrella company, the tax responsibilities are largely managed by the company itself. The umbrella company deducts the necessary tax and NICs from the contractor’s salary before paying them. The company is responsible for accurate payroll processing, making tax deductions, and submitting the necessary documents and payments to HMRC on behalf of the contractors.
Claiming Expenses
Both limited companies and contractors working through umbrella companies can claim business expenses to reduce their taxable income. However, there are differences in how these expenses are claimed.
In a Limited company, the company can claim a wider range of expenses, including office rent, equipment costs, professional fees, and travel expenses. These expenses are deducted from the company’s profits, reducing the amount of corporation tax payable. Shareholders can also claim expenses related to their duties as directors, such as training courses or professional memberships.
In an umbrella company, contractors can claim expenses that are directly related to their work, such as travel and accommodation expenses incurred for business purposes. However, the rules around expense claims for umbrella company contractors are more restrictive than those for Limited companies. Contractors should consult with their umbrella company and tax advisors to understand the specific expenses they are eligible to claim.
Financial Considerations
Income
In a Limited company, a contractor’s income is generated through the contracts they secure. The company invoices clients for the work done and receives payment into its business bank account. From this income, the company pays its expenses, including salaries, supplier bills, and other allowable costs. The remaining profit can be distributed to the shareholders as dividends.
In an umbrella company, the contractor’s income is derived from the fees charged for their services. The umbrella company invoices the client or recruitment agency for the contractor’s work and collects payment on their behalf. The umbrella company then calculates the contractor’s salary, deducts taxes, NICs, and its administration fees, and pays the contractor the net salary.
Profit Distribution
In a Limited company, profits can be distributed to the shareholders in the form of dividends. The distribution of dividends is decided by the shareholders, typically based on their shareholdings. Dividends are subject to dividend tax, which has separate rates and thresholds from income tax. Shareholders can determine the timing and frequency of dividend payments, allowing for flexibility in managing their personal income and tax liabilities.
In an umbrella company, there is no profit distribution to the contractor as an owner. Instead, the contractor receives a net salary as an employee of the umbrella company. This salary is subject to PAYE tax and NICs, which are deducted by the umbrella company before paying the contractor.
Administrative Burden
Accounting and Bookkeeping
When operating as a Limited company, contractors have a greater administrative burden compared to working through an umbrella company. Limited companies must maintain accurate financial records, including bookkeeping, invoicing, and record-keeping of income and expenses. They are also responsible for preparing and submitting annual financial statements, which can be complex and time-consuming. Contractors may choose to outsource these tasks to an accountant or bookkeeper to ensure compliance and accuracy.
In an umbrella company, the administrative burden is significantly reduced. The umbrella company takes care of tasks such as invoicing clients, processing payments, and maintaining proper financial records. This can save contractors time and effort, allowing them to focus on their work rather than administrative tasks.
PAYE and National Insurance
In a Limited company, contractors are responsible for calculating and paying their own income tax and National Insurance Contributions (NICs). They must stay updated on the relevant tax rates, bands, and allowances, and ensure timely submission and payment of taxes to HMRC. Contractors may engage the services of an accountant to handle their payroll and tax obligations, or use accounting software to streamline the process.
In an umbrella company, the responsibility for PAYE tax and NICs lies with the company itself. The umbrella company calculates and deducts the necessary taxes and contributions from the contractor’s salary, ensuring compliance with HMRC regulations. This relieves contractors from the burden of managing their own payroll and tax responsibilities.
Business Administration
Operating a Limited company involves additional business administration tasks compared to working through an umbrella company. Limited company contractors need to manage company bank accounts, maintain proper company records, and handle company filings and compliance requirements. They may need to register for VAT if their turnover exceeds the VAT registration threshold. Contractors may seek professional advice and support to navigate these administrative tasks effectively.
In an umbrella company, most of the business administration tasks are handled by the company itself. The umbrella company takes care of tasks such as company filings, compliance requirements, and managing the company bank account. This can alleviate the administrative burden on contractors, allowing them to focus on their work.
Setup and Maintenance
Incorporation Process
Setting up a limited company involves several steps. Contractors need to choose a company name that is unique and not already in use, and register the company with Companies House. They must also define the company’s Articles of Association, which outline the rights and responsibilities of the shareholders and directors. Additionally, contractors need to provide information about the company’s registered office address, directors, and shareholders. The process can be completed online, and there are various formation services available to assist with the setup.
Joining an umbrella company, on the other hand, is a simpler process. Contractors typically need to sign a contract with the umbrella company, providing their personal and contract details. The umbrella company may also require supporting documents such as identification and proof of address. Once the contract is in place, the contractor can start working through the umbrella company.
Reporting and Compliance
Operating as a limited company requires ongoing reporting and compliance with legal requirements. Companies must file annual financial statements, including balance sheets, profit and loss accounts, and director’s reports, with Companies House. The company’s accounts must comply with accounting standards, such as UK Generally Accepted Accounting Principles (UK GAAP) or International Financial Reporting Standards (IFRS). Additionally, limited companies must comply with other regulations, such as data protection laws and anti-money laundering regulations.
In an umbrella company, compliance requirements are largely managed by the company itself. The umbrella company handles the preparation and submission of financial statements and ensures compliance with relevant legislation. As an employee of the umbrella company, contractors do not have direct reporting responsibilities but must provide accurate and timely information to the umbrella company for payroll processing.
Professional Support
When setting up and operating a limited company, contractors may seek professional support to navigate various aspects of running a business. This can include engaging the services of an accountant or bookkeeper to handle financial matters, such as payroll processing and tax obligations. Contractors may also seek legal advice to ensure compliance with relevant laws and regulations. Professional support can help contractors streamline their business operations and ensure compliance with legal and financial requirements.
When working through an umbrella company, contractors have access to professional support through the company itself. The umbrella company provides administrative and financial support, relieving contractors from the need to engage additional professionals. The umbrella company’s expertise in payroll processing, tax compliance, and legal matters can provide contractors with peace of mind and ensure they are operating within the necessary guidelines.
Flexibility and Control
Flexible Working
Working as a limited company contractor offers flexibility and control over one’s work. Contractors have the freedom to choose their clients, set their own rates, and negotiate the terms of their contracts. They can work on multiple projects simultaneously and have more autonomy in managing their time and workload. Limited company contractors can also adapt their services and work arrangements to suit their preferences and lifestyle, providing them with a higher level of flexibility.
Contractors working through an umbrella company, however, may have less control over their work arrangements. The umbrella company typically engages them on a contract basis with specific clients, limiting their independence and freedom to choose projects. The terms and conditions of their employment, including rates and hours of work, may also be determined by the umbrella company or the client. While the umbrella company provides administrative support, the level of flexibility and control may be more limited compared to operating as a limited company.
Client Relationships
Operating as a limited company allows contractors to establish direct relationships with their clients. They can build long-term partnerships and develop a deep understanding of their clients’ needs and preferences. By working closely with clients, limited company contractors can align their services to meet specific requirements and deliver tailored solutions. The direct client relationships can also result in repeat business and referrals, contributing to the contractor’s success and growth.
In an umbrella company arrangement, contractors may have less direct contact with clients. The umbrella company acts as an intermediary between the contractor and the client, managing the contractual and administrative aspects of the relationship. While contractors may still have important interactions with clients during the delivery of their services, the relationship dynamic may be different compared to working as a limited company contractor.
Financial Risks
Liability
One of the key advantages of operating as a limited company is limited liability for shareholders. In the event of financial difficulties or legal issues, the shareholders’ personal assets are generally protected. The company’s liabilities are limited to its assets, and creditors cannot pursue the shareholders’ personal wealth to settle corporate debts. Limited liability provides a level of financial security and peace of mind to the shareholders.
In an umbrella company arrangement, contractors are engaged as employees of the company and do not have direct liability for the company’s debts. The umbrella company is responsible for its financial obligations, and contractors are shielded from any liabilities that may arise. This can provide contractors with a level of security and protection, similar to that of traditional employees.
Insolvency Protection
While limited liability provides protection to shareholders, limited companies can still face financial risks, including insolvency. Insolvency occurs when a company is unable to pay its debts as they fall due or has liabilities exceeding its assets. In such cases, the company may enter liquidation or administration, and its assets are used to settle debts.
Contractors working through an umbrella company have a lower risk of being directly impacted by the insolvency of the company. As employees, they are entitled to certain protections under employment legislation. In the event of the umbrella company becoming insolvent, contractors may be protected through the government’s Insolvency Service, which ensures payment of outstanding wages, holiday pay, and other entitlements owed to employees.
Industry Suitability
Contracting vs Permanent Employment
The choice between operating as a limited company contractor or working as a permanent employee depends on various factors, including the industry and individual preferences. Certain industries, such as IT, engineering, and creative sectors, have a strong demand for contractors, making limited company contracting a popular choice. Contractors in these industries can benefit from higher hourly rates, diverse project opportunities, and the ability to work on different assignments.
In contrast, some industries may have a preference for permanent employees. These industries, such as healthcare, education, and public sector, require long-term commitment and continuity of service. Permanent employees in these sectors enjoy job security, employee benefits, and career progression opportunities. Working through an umbrella company may be more common in industries where temporary and short-term contracts are prevalent.
Sector Specific Considerations
Different sectors have specific considerations when it comes to choosing between a limited company and an umbrella company. For example, in the construction industry, contractors often opt for limited company status due to the nature of the work and the potential for subcontracting. Limited company contractors can work as subcontractors to larger construction companies, providing specialized skills and services.
In industries such as healthcare or teaching, where contractors may be engaged on a temporary basis to cover staff shortages or specific projects, working through an umbrella company is more common. The umbrella company can provide the administrative support and employment structure needed for temporary or short-term engagements.
When it comes to Limited company versus umbrella company, the choice depends on various factors, including personal preferences, industry norms, tax considerations, and the level of administrative burden one is willing to undertake. Contractors should carefully evaluate their circumstances, seek professional advice, and consider their long-term objectives before deciding on the most suitable business structure.
