Contractors: the pros and cons of using an umbrella company

As a contractor, you will probably have to operate via a limited company rather than be a sole trader.

You could set up your own one-person company, or use a UK umbrella company.

An umbrella company gives you the option of having an employer while still working on a contracted basis. That means you don’t have to worry about tax returns, as they’ll take care of it for you.

But what are the pros and cons of being a contractor through an umbrella company? Let’s find out.

What is an umbrella company?

Umbrella companies act as third party employers for contractors.

As the contractor, you can still choose the projects you work on, but you have an employer taking care of your employment admin. They tend to handle administrative tasks such as payroll and tax deductions, allowing contractors to focus on their work.

How do umbrella companies work?

All umbrella schemes work in the same way, no matter whether you are a builder, IT contractor, graphic designer or whatever.

When you’re contracted to work on a project, the umbrella company will invoice your client for the work and collect payment.

You’re enrolled on the umbrella company’s PAYE system and they pay you an income from the invoice after deducting items like tax, National Insurance contributions and agreed fees.

They will also deduct any applicable expenses, but these will normally need to be agreed by the client first.

How much tax do you pay under an umbrella company?

Even though you’re a contractor, HMRC considers you a permanent UK employee when you work under an umbrella company.

You’ll be given a tax code and pay a basic, higher or additional rate based on your income – just as you would if you were employed by a company full or part time. 

How much take home pay would I get working for an umbrella company?

Your take home pay will depend on your tax rate and the fee the umbrella company charges, which comes in two forms:

• Fixed fee – this is a flat fee the company charges every week or month. It is typically around £100 a month.
• Percentage fee – this fee is charged as a percentage of your income. It is often around 5%, which can hit higher earners more.

Fees can vary significantly among different umbrella companies and might include additional costs for compliance checks, insurance, or benefits packages.

As a contractor, should I use an umbrella company?

Umbrella companies are a legitimate business structure, but be careful to avoid any that might be bending the rules.

For example, steer well clear of any that appear to be offering offshore schemes or other tax avoidance mechanisms. If it looks too good to be true, it may get you into real trouble.

Many companies that use contractors may insist that you operate via a company, so they don’t fall foul of IR35 legislation.

Joining an umbrella company is quicker and easier than setting up your own. You may even choose to use an umbrella company temporarily while planning to start your own company.

Here are the main pros and cons of using an umbrella company:

The advantages of an umbrella company:

• All your income tax payments are taken care of, so you don’t need to submit a tax return
• As an employer, you get statutory sick, maternity/paternity and holiday pay, and enrolment onto a pension scheme
• Some companies also offer benefits like health insurance, access to welfare services and benefits packages

Disadvantages of an umbrella company:

• You will pay fees, meaning it might not be so cost-effective
• Some umbrella companies act in illegitimate ways, so it’s important to carefully check what you are signing up for
• You might find it more tax efficient to set up a limited company

Which is best: umbrella company or a one-person limited company?

Many contractors prefer to set up as their own limited company rather than use an umbrella company.

This route can be more cost-effective, because you won’t have to pay fees to anyone else, and you have more tax freedoms.

For example, you can pay yourself in a combination of a basic salary and dividends to reduce the tax you pay.

You could also transfer some shares to a spouse so that they can receive dividends too and use their tax-free allowance.

If you choose to operate as a one-person limited company, your company is considered a separate legal entity from yourself, thus reducing your individual liability (compared to being a sole trader).

You will, however, be a company director responsible for your statutory and financial obligations. That means you need to pay corporation tax, add VAT to your invoices and submit annual accounts to Companies House – but an accountant can do all this for you.

Other factors to consider include the risks you’re willing to take, whether or not you need business insurance, the kind of work you do and your income.

Your accountant and/or financial adviser can guide you on the most appropriate routes.

What’s the situation for umbrella companies with the IR35 changes?

The IR35 rules make sure that contractors who are treated in the same way as their client’s employees cannot avoid tax by operating as a limited company.

If you are an employee in all but name, you would be considered ‘inside the IR35 rules’ and be required to pay additional tax.

The responsibility for deciding if a contractor is within the IR35 rules falls to the employer. Public companies already need to do this, but private companies must follow suit from April 2021.

From April 2024, new rules have been introduced to reduce the risk of double taxation. If a contractor is wrongly classified as ‘inside IR35,’ businesses can now offset taxes already paid by the contractor, such as corporation tax and income tax, against their PAYE liabilities.

This change aims to prevent excessive financial penalties and ensure fairer tax treatment for both contractors and businesses.

If you are genuinely a freelancer operating through a limited company, the IR35 rules shouldn’t apply to you, but it’s a good idea to double-check and take steps to ensure you are not ‘mistaken for an employee’ by HMRC.

How do I get set up under an umbrella company?

If you decide that working under an umbrella company is the right option for you, it’s easy to get set up.

The first task is finding the company you want to be employed through. Then it’s merely a case of checking and signing the contract, supplying your details and informing your clients.

Get expert financial advice

Choosing between using an umbrella company or setting up a one-person limited company depends on your personal circumstances, the nature of your work, and how much administrative responsibility you're willing to take on.

Umbrella companies offer simplicity and security for those who want to avoid the hassle of handling taxes and paperwork, but they come with fees and less control over tax planning.

On the other hand, running your own limited company can be more tax-efficient and financially rewarding, but it requires more effort and knowledge to manage. Consider your options carefully and seek professional advice to determine the best route for your contracting career.

Let Unbiased match you with a financial adviser for expert financial advice on whether using an umbrella company or setting up your own limited company is the most cost-effective and tax-efficient option for your contracting needs.