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A contractor is one who provides services to a specific client under specific terms. They can be classified either as an employee or as self-employed. With the former, they work for a client through an umbrella company or agency. As the latter, they work independently or have a limited company of their own. If you decide to work as a contractor, you will be responsible for your own business dealings. You will have control of how and when you will do your work. There are also various benefits that you can derive from working as a contractor.

Control over work

As a contractor, you will have more freedom in choosing what work to accept or reject. You are not obliged to accept a contract. An employee is obliged to do the work provided by their employer. A contractor, on the other hand, has a contract for services with a client on an agreed schedule. They assume liability for any errors or omissions. Once the project has been completed, client is not required to offer more work to the contractor.

Freedom over when and where to work

If you work as a contractor, you decide when and where to work. You may be required to work on the client’s site at some point. While your client may have a clear idea of the required deliverables, they cannot control your working patterns. Your compensation will be based on the completion of specific ‘milestones’ which is defined in the contract.

Tax Benefits of Contractors

Contracting work offers both tax advantages and disadvantages. As a contractor, you are not entitled to employee rights and benefits such as redundancy pay, holiday, and paid sick days afforded by employers.

Rights of Contractors

Contractors are not entitled to receive sick pay and other benefits given to employees. However, they have some legal rights protected by the law such as right against discrimination and a right to a safe and healthy working environment. If you are working for an employment agency, you also have rights supported by the Conduct of Employment Agencies and Employment Business Regulations 2003. Also, you do not have the right to redress if the client decides to end your service or choose not to renew your contract. The termination process should, however, be clearly set out in your contract.

Legal structures for contractors

The first thing you need to consider when starting out as a contractor is to decide on a suitable legal structure. Up until the 1980s, contractors operated as a sole trader. Things changed, however, when the HMRC came up with a ruling making recruitment agencies liable for unpaid tax if they hired self-employed workers and paid them gross. This prevented recruitment agencies from hiring sole traders. As a result, contractors were forced to set themselves up as a limited company.

When the IR35 was introduced in 2000, different company structures evolved. Deciding on what structure to use depended on various factors such as whether or not contractors are covered by the IR35 rule. It is therefore important to have a little knowledge of the IR35 rule.

Many contractors contract through Limited Company because it is the most tax efficient way to function. This is because a Limited Company typically takes a small salary, which minimises PAYE (Pay As You Earn) and NIC (National Insurance Contributions) liabilities. The remaining income will be in the form of dividends.

Before anything, you have to determine whether you are inside or outside contractors IR35. IR35 is tax legislation in the UK. It seeks to battle tax avoidance by workers giving services to clients through Limited Company. You have to prove that you are not a “disguised employee” or you are outside IR35. A true contractor will most likely be outside of IR35.

If you are exposed by IR35, you will suffer higher tax. Many contractors consider Limited Company because it increases their take home. However, you need to know that you will be liable for a number of business taxes including personal taxes. Here are some taxes to consider for Limited Company contractors:

Corporation tax
You have to know that all limited companies are subject to Corporation Tax. This is at 19%. If you are caught by IR35, your expenses and salary will be equal to the company’s income. With this, the company will make little net profit and very little payable Corporation Tax.

If you are not caught by IR35, you will take a low salary combined with high dividends. Remember that dividends are only paid from company profits. With this, you need to pay Corporation Tax at 19% of your net company profit. It is payable for nine months.

Value Added Tax
Majority of contracting companies are registered for VAT. If your company is registered for this, you need to charge VAT on your invoices with a standard rate of 20%. Do not worry because VAT does not affect the profit of your company. The company will collect VAT on behalf of HMRC (Her Majesty’s Revenue and Customs).

Employer’s NICs
NIC is considered a company cost based on the amount of your gross salary. The rate is 13.8%. If your contract is caught by IR35, your salary will be higher and the amount of NIC will be based on your salary. If your contract is not caught, the best thing to do is to take a low salary to avoid NIC. NIC is not chargeable on company dividends.

Personal taxes
Personal taxes include Income Tax and Capital Gains Tax. If your contract is caught by IR35, your whole income from the company will be subjected to PAYE; it will then be subtracted at the source. If you are not caught, a small amount of your Income Tax liability will be subtracted via PAYE. For IR35 exempt contracts, you can receive dividends having 7.5%, 32.5%, and 38.1% rates. If you close your company and distribute the capital to yourself as a shareholder, you are subjected to Capital Gains Tax.

Your goal here is to be outside IR35. You need proof if HMRC deems necessary. You can show documents and contracts but it can be set aside if the judge sees it as a sham. What you can do is to show your working practices to prove that you are a contractor or self-employed.