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What is a Limited Company?

A Limited Company is a legal entity in its own right which can buy or sell products and services to other businesses or consumers. Have more questions? Talk to the team at Umbrella Supermarket today.

A Limited Company is owned by its shareholders (people that literally own a share of the business) and controlled by its directors (who work in the best interests of the shareholders). The two do not need to be the same people, but in many small businesses they are.

As contractors are often the sole directors and shareholders of their Limited Company, a contractors Limited Company is often referred to as a Personal Services Company (PSC).

This distinction is made because the PSC sells only the personal services of the contractor and no other goods or services. In certain circumstances multiple contractors might own a share in and operate through a single Limited Company although this arrangements limits the control of any single contractor as it will have a board of directors.
As a director, the contractor is liable for the regulatory upkeep of the company. This includes statuary document filing such as accounts and annual returns. In order to help administer the company, most contractors will partner with an accountant who will prepare the documents and do the filing on their behalf.

In the UK, a special form of Limited Company service exists for contractors that want to work through a company but without the liability or hassle of a Limited Company.

Umbrella Companies are designed to remove the need for contractors to become shareholders or directors. Additionally, an Umbrella Company employs the contractor in order to process their payroll and provide them with basic insurance cover.

Limited Company Benefits

While the business itself is its own legal entity, because it cannot make decisions for itself, the directors of that business are required to make decisions on its behalf. As such the directors can be held liable in the event that the business takes on liabilities that it cannot fulfil when trading insolvently or in the event that it breaks the law.

On the other hand the shareholders liability is limited to the financial value of their stake in the business, where as their share of the profits is limited only by their percentage of the shareholding. In addition, there are tax benefits to being a shareholder that enable owners to extract company profits at a tax rate lower than if these funds were ordinary income.

Because of the separation between control, ownership and liability, a Limited Company structure is usually considered to offer the directors and shareholders a degree of protection from its debts should it be forced to close.

Aside from being a lower risk way to contract out your services than trading on your own account there are also several benefits to contracting through a Limited Company:

  • You’re your own boss
  • You can build a brand and profile for your business in your sector
  • You have continuity of formal accounts despite several contracts
  • You can diversify your business interests into other services or products
  • You can take on employees
  • You can offset certain expenses against your profits to lower your tax bill

How will you get paid through a Limited Company?

Working through a Limited Company is often considered to be more financially beneficial than working through alternatives like an Umbrella Company.

This is because as a director and a shareholder, contractors have access to both the PAYE payroll system and the dividend mechanism through which shareholders can extract the company’s profits.

In order to minimise their tax liability, it is not uncommon for contractors using their own Limited Company to minimise their salary, and thus reduce their income tax along with employers and employees National Insurance Contributions.

The rest of a contractor’s income is made up through dividend payments. Dividend payments are not subject to income tax or national insurance and have their own tax applied.

In the 2019/2020 tax year any contractor taking a dividend with be able to extract the first £2,000 of dividends without any tax applied at all (over and above the £12,500 personal allowance on any salary).

The current rates of tax on dividends are:

  • Basic Rate Tax Payers – 7.5% (From £2,000 to £37,500)
  • Higher Rate Tax Payers – 32.5% (Earning from £37,501 to £150,000)
  • Additional Rate Tax Payers – 38.1% (Earning above £150,000)

As a practical example, imagine that a contractor can bill £37,500 for a full year of contracting, this is how they would get paid through their Limited Company:

  • Salary £12,500 (same as personal allowance)
  • Dividends £35,000 (effectively £33,000 as £2,000 is tax free)
  • Total taxable income £33,000 (subject to basic rate of 7.5%)
  • Tax Due: £2,475
  • Take home: £35,025

Rather than pay this dividend tax upfront, the contractor will need to hold this money back to one side and complete a self-assessment at the end of the year to declare the tax they must pay.

What’s the difference between Limited Company Payroll and Umbrella Company PAYE?

Working through an Umbrella Company’s PAYE can be lower hassle than running a Limited Company, however it is often not as financially rewarding.

When choosing whether to operate through an Umbrella Company or a Limited Company, it’s important to weigh up financial benefit verses any administration hassle (e.g. sending invoices & filing accounts).

Financially the rewards offered through both routes differ considerably.

Taking the earlier financial example, through Umbrella PAYE, a contractors billing £37,500 will take home £25,609. That’s £9,416 less than through a Limited Company using a salary and dividend mix.

The reason for the majority of this difference is three fold.

  1. The tax on earnings above the £12,500 threshold for an employee is 20% for PAYE, not 7.5% via dividends.
  2. The contractor will need to deduct the Employers National Insurance contributions on their salary from their gross pay.
  3. The contractor will pay a fee each week for the services of the umbrella company.

What is IR35?

At face value working through a Limited Company is more financially rewarding than working through either an Umbrella Company or employed PAYE.

In fact due to this tax benefit many full time employees might want to explore contracting, while Umbrella Company contractors might choose to switch to a Limited Company.

Equally many employers might wish to turn their employees into contractors to save on Employers National Insurance contributions.

In response to a wave of transitions from employees to contracting, the UK government acted to introduce legislation to protect their tax receipts (which would suffer as a result).

The issue at hand was to tackle where employers and employees were deliberately entering into contracting arrangements in order to lower their tax payments.

The IR35 rules were therefore designed to spot “falsely” self-employed workers and make them (and their employers) pay taxes as if the contractor were employed. The first batch of IR35 rules spanned both the public and private sectors, focusing on the contracts contractors were entering into.

Contracts were scrutinised to look for clues that the contractor was in fact under the same direction and supervision as an employee. In reality a genuine contractors should be free to perform their role when and how they see fit.

When reviewing a contract HMRC would focus on key facts such as:

  • Does the contractor need to book in their holidays like an employee would?
  • Does the contractor need to wear a uniform like an employee would?
  • Does the contractor have a desk or defined place of work like an employee would?
  • Does the contractor have the right to send someone else to do their work?
  • Does the contractor have to manage a team or be managed as part of a team?

In the event that the contractor appeared to be subject to the same working practices as an employee, HMRC would deem them “inside IR35” and issue demands for Employers National Insurance from the employer and expect the contractor to process their payroll through PAYE.

In reality, despite working practices failing the IR35 tests, prior to April 2017, contracts were written to ensure they passed any IR35 scrutiny.

In April 2017 however, HMRC stepped up their IR35 game. As part of a two part reform program (the private sector part coming in April 2020) the government revised the IR35 rules for the public sector.

In effect rather than looking at an actual contract, the government placed the responsibility for IR35 compliance upon the recipient of the work. In practice this meant an NHS Trust or another government department would look at their contractors working practices when deciding if they were inside IR35.

In response to this new responsibility, NHS trusts in the UK and other government departments declared their contractors inside IR35. Once declared inside IR35, the low salary, high dividend mix that made Limited Companies financially beneficial was effectively dead in the water.

As it stands today, any contractors caught by IR35 in the public sector must process their payroll through PAYE, effectively rendering the use of a Limited Company for these contractors pointless. As a result of IR35 a Limited Company became no more financially rewarding than an Umbrella Company despite the extra hassle.

How to find the best accountant for your Limited Company

If you’re looking for the best accountant to help you set up and operate your contractor Limited Company, it’s important first that you establish if you’re caught by IR35.

In order to do this, there are a number of IR35 tests available online however the only official test can be found here. This “CEST” test has been heavily criticised in the media and proved on more than one occasion to be incorrect in the courts but as it stands it’s the only government guidance offered.

If you’re not caught by IR35, it’s important to compare accountants online and understand the benefits they offer you over each other.

Not all accountants were created equal. On face value the different fees on offer can mask the service level you’re getting. Perhaps you want a personal service that allows you to call an accountant, or maybe you want a fully automated system where human interaction is kept at a minimum. A comparison site will help you make this distinction.

In 2019 umbrellasupermarket.co.uk launched our accountant comparison service to go alongside our market leading umbrella company comparison tool to help contractors do just that.

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