Updated on: Nov 19, 2023
Today we’re going to consider the case of a contractor who is working in the UK and is wanting to consider the tax effects of working as a sole trader, through a limited company, and via a PAYE umbrella company.
I want to use the example to illustrate how a limited company can be used to store income within the company on the basis the contractor does not need the money to live on, and how that money can be finally extracted from the company when it is closed down.
I will use the exact same set of data for all three contractor tax calculator scenarios and lets assume that the contractor is going to be working for three years on various projects. Before I get started though let’s take a look at the three different contracting models and discuss how each might apply to the scenario.
Limited Company Contractor
The first scenario will have our freelancer working as a limited company contractor. We have numerous blog articles about getting set up as a limited company, setting up a business bank account, and comparing limited company contracting to being a sole trader. Working as a limited company became more difficult with the introduction of the IR35 off payroll rules that were introduced for private sector workers in 2021.
Large organisations are slowly adapting to these new changes and many are realising that to attract the top talent they need to have systems and processes in place that comply with the off-payroll rules so that they can engage contractors through their own limited company. A lot of our limited company clients get work in these large organisations through recruitment firms. The IR35 changes did not affect small businesses however, and our clients continue to get contracting work through personal referrals, word of mouth, and the odd recruitment firm into these smaller organisations also.
Working as a sole trader in the UK is the simplest and fastest way of getting set up as a contractor. The compliance and reporting requirements are significantly less than as a limited company contractor which is why it’s such a common route for people starting out as contractors. In our “Exploring the Advantages and Disadvantages of Sole Traders” blog article we discussed why sole traders cannot get work through recruitment firms. As a result, if you’re looking for contracting work through an agency your most likely options will be working as a limited company contractor, through an Umbrella, or working as a PAYE employee of the agency itself.
For our sole trader calculator example, we will assume that our contractor is working for a small organisation and that they found the work through word-of-mouth referral and that no agency is involved.
The final calculation scenario we will look at is the contractor working through a PAYE Umbrella company. With the introduction of the IR35 off payroll rules for private sector workers in 2021, the use of Umbrella companies received a significant boost. This is because the recruitment agency and the end client could now face tax liabilities relating to the work done by a contractor working through their own limited company if the worker had been incorrectly classified as self-employed. Immediately after the introduction of the IR35 rules many recruitment firms and end clients swiftly moved to de-risk their engagement of contractors by banning the use of limited company contractors, often without considering the specifics of each engagement.
For our PAYE umbrella calculator example we will assume the contractor is working for a small organisation who has engaged the use of No Worries Red Umbrella (an FSCA accredited firm) to handle the payroll for all of their contractors.
Tax rates and tax bands
Although this scenario will be running over three years we will use the same tax rates and tax bands for 2023/24 across all three years. These bands usually change every year so it’s not a completely accurate way of determining the total tax payable each year because those bands for future years have not yet been published. However, because we’re mainly looking at a comparison between three different options it really doesn’t make much difference here.
The tax bands and tax rates we will use are:
National insurance rates
Employees NIC, 12% on salary over £12,570, and up to £50,270
Employers NIC, 13.8% on salary over £9,100
Class 2 NIC (sole traders), £3.45 per week
Class 4 NIC (sole traders), 9% on profits over £12,570, and up to £50,270
Class 4 NIC (sole traders), 2% on profits over £50,270
Income tax rates
PAYE, 20% on salary over £12,570, and up to £50,270
PAYE, 40% on salary over £50,270, and up to £125,140
Dividend tax rates
Dividend tax, 8.75% on dividend income over £12,570, and up to £50,270
Dividend tax, 33.75% on dividend income over £50,270, and up to £125,140
Corporation tax rates
19% of taxable profits if profits do not exceed £50,000
25% of taxable profits if profits exceed £250,000
For taxable profits between these two thresholds, the tax rate increases in proportion from 19% to 25%.
Our contractor Mia has just picked up a new 6-month contract working for a small company just outside of London. Her agreed contract rate is £350 per day. Mia has decided to use No Worries as her accountant and would like to know the difference between working as a limited company, sole trader, and Umbrella worker. To make the comparison as fair as possible Mia has asked that we include our professional services charges in the calculation, along with expenses of £85 per week which would cover travel costs, mobile phone, and membership to her professional organisation. The end client Mia will be working for recognises that these expenses cannot be paid when she is working through the Umbrella company, so they have agreed to make her rate £370 per day if she works through the Umbrella company option.
Mia has no other forms of income, and is on the normal 1257L tax code for 2023/24. Her annual living costs means that she would like an overall net pay of £45,000 per year (after tax paid into her personal bank account). She intends to work 45 weeks of the year, so this equates to £1,000 net pay for each week worked.
Over the course of the year the total income that Mia earns as a sole trader or limited company contractor will just be below the VAT registration threshold, so to keep things simple we will exclude VAT registration from this scenario. If she were to register for VAT then the net pay figures that we calculate below for the sole trader or limited company options will get slightly better.
She plans on contracting for the next three years and expects to pick up contracts of the same value over this period of time for various durations.
How much tax will Mia pay over the next three years?
Umbrella tax calculator
Let’s start with the easiest calculation, which is with Mia working through a PAYE umbrella. Mia’s end client agreed to pay her a daily rate of £370. Working through an umbrella there are no expenses that she can claim, so this is effectively a simple payroll calculation.
An umbrella company has various administrative overheads that need to be deducted from the daily rate before we can arrive at the gross salary amount. These overheads are employers NIC, apprenticeship levy, and the umbrella margin (this is the cost “charged” by the umbrella company and is the main source of income that they have).
Timesheet income = £350 x 5 = £1,750
Less Administrative overheads of £215.31
Gross weekly salary = £1,534.69
PAYE and NIC deductions for the week = £470.15
Total net pay = £1,064.54
There are no tax planning of options available here, and Mia is simply left with a net pay of £1,064.54 being paid into her personal bank account every week. Over a period of 45 weeks of work, this translates into an annual net pay of £47,904.30 which meets Mia’s living requirements. Note that the way PAYE is calculated and on the basis that there is 7 weeks in the year that she does not work, her net pay will actually be a little bit higher than this but for simplicity let’s just keep it as is.
Total taxes and accounting fees paid for the year (including administrative overheads) is 686.46 x 45 = £30,845.70. Over the three-year period this translates to £92,537.10 in total taxes and accounting fees paid.
Sole trader tax calculator
Next up let’s look at the sole trader tax calculation. Mia’s end client agreed to pay her a daily rate of £350 as a sole trader, she has £85 per week of business expenses, and the No Worries sole trader accounting service costs her £35 + VAT (£42) per month.
Annual trading income = (5 x 350) x 45 = £78,750
Annual expenses = (85 x 52) + (42 x 12) = 4,420 + 504 = £4,924
Annual trading profit = £73,826
Employers NIC Class 2 due: 3.45 x 52 = £179.40
Employers NIC Class 4 due: £3,864.12
Income tax due: £16,962.40
Every year Mia pays tax and NIC based on her sole trader profit. Unlike with a limited company, there is no way of deferring any elements of this income into future years so the full profit every year gets taxed.
Total taxes and accounting fees paid for the year is 504 + 179.40 + 3,864.12 + 16,962.40 = £21,509.92. This gives Mia a net pay (per week worked) of £1,272 along with the reimbursement of expenses of £85 per week.
Over the three-year period she pays £64,530 in total taxes and accounting fees working as a sole trader.
Limited company calculator
Finally let’s look at the scenario where Mia works through her own limited company. The administrative set-up is a little bit more involved and the No Worries accounting fee becomes £85 + VAT (£102) per month for our basic Gold service.
In this scenario we add one further expense to the business, and that is a salary for Mia. For the 2023/24 tax year we make this £9,096 per year.
Mia wants to be paid a net total of £45,000 per year to meet her living expenses. Her gross salary of £9,096 will not have any tax deductions, so the total dividends that she will require for the year will be 45,000 – 9,096 = 35,904. The combination of her salary plus dividends will equate to £45,000 per year.
Annual trading income = (5 x 350) x 45 = £78,750
Annual expenses = (85 x 52) + (102 x 12) + 9,096 = 4,420 + 1,224 + 9,096 = £14,740
Annual trading profit = £64,010
Corporation tax = £13,213
Dividends paid each year = 45,000 – 9,096 = 35,904
Funds retained in the business each year = 64,010 – 13,213 – 35,904 = £14,893
Tax due on dividends = £2,750
Total taxes and accounting fees paid for the year is 1,224 + 13,213 + 2,750 = £17,187. Also, Mia gets a net pay (per week worked) of £1,000 along with the reimbursement of expenses of £85 per week. In addition to this there are further tax planning opportunities for Mia because she has been able to leave £14,893 behind in her business each year. At the moment this income has only been taxed at the corporation tax rate.
If Mia chooses to continue to keep that money behind in her business then after a three-year period there will be surplus retained earnings in the company of 14,893 x 3 = £44,679. So not only has Mia managed to extract £1,000 per week to meet her living costs, over a three-year period, her company has also managed to save a significant amount of money. If after three years she closes down her company and extracts those funds via our members voluntary liquidation, her total taxes and fees involved in getting that money out of her business will total approximately £5,700 under the current text settings.
So over the three-year period Mia will have paid £57,267 in total taxes and accounting fees working as a limited company contractor.
Working through a limited company will be the most beneficial option for Mia. Particularly the ability to withhold income from being taxed at the personal tax rates until the company is being closed down is of benefit for Mia. This can also be used for income smoothing if there are extended periods of time where Mia is not working, she can continue to draw funds from her business if it has sufficient retained earnings. A summary of the total tax paid over three years for the three options is shown below.
|Total tax paid over 3 years
If you are looking to start contracting in the UK and have any questions around these three contracting models feel free to get in touch. We would be happy to help.