Updated on: Feb 19, 2024
With the new year now behind us I thought January would be a good time to recap on the taxes that limited company contractors are liable for when working through their own limited company. This guide will be particularly useful for contractors looking to use a limited company for the first time, for those who have been working for several years this guide is really just a refresher course.
Decoding contractors tax obligations can be challenging if you are new to contracting. You’re likely looking for ways to efficiently manage your taxes and maximize your earnings as a contractor. Our guide dives into four main business tax types that affect you, strategies for income management, and compliance tactics without overwhelming jargon.
- Understanding corporation tax, income tax, national insurance, and VAT is essential for contractors to navigate the tax system and make informed financial decisions, with careful planning required to optimize tax liabilities. In this article, any tax rates that we reference where will be relevant for the 2023/24 tax year.
- The balance between salary and dividend income is crucial for tax efficiency, whereby drawing a reasonable salary and supplementing with dividends can lead to tax savings, considering personal allowances and the impact of different tax rates.
- Contractors must remain compliant with IR35 legislation to avoid being deemed ‘disguised employees’ and to reduce the risk of increased taxation; understanding the implications of IR35 on limited company contractors and the exemption of umbrella company contractors is vital. We have previously covered issues surrounding IR35 with our blog articles IR35 News, Contractor status: Inside IR35, and Surviving IR35: Options if Your Client Won’t Hire Outside IR35.
Understanding Contractor Taxes
For newbies, the world of contractor taxes and tax law can seem labyrinthine, with various types of taxes interplaying in different ways. Grasping the concepts of:
- Corporation Tax
- Income Tax
- National Insurance
- Value Added Tax (VAT)
is fundamental to steer through what can seem like a complex landscape and handle your finances effectively.
Corporation Tax, for instance, is a significant consideration for contractors, levied at a (starting) rate of 19% on company profits. Grasping this concept is super-important for financial planning, especially when deciding on salary and dividends. Meanwhile, Income Tax plays a different role, being paid on salary and factoring into the balance between salary and dividends.
National Insurance Contributions (NICs) also have a twofold impact, influencing both employers and employees. Finally, Value Added Tax (VAT) presents its own considerations, with contractors needing to account for it on a quarterly basis and potentially needing to register for VAT.
Corporation Tax for Contractors
Corporation Tax is a fiscal obligation imposed on limited companies, specifically on their annual profits. For most of our contractor clients, the current rate is 19%, and is applied to the yearly profits of the company. But how are these profits calculated? Generally speaking for the vast majority of our clients, corporation tax is calculated from taxable profit, which is total income less expenses plus entertainment expenses plus depreciation less capital allowances. The ‘small profits rate’ of 19% applies to profits of £50,000 or less. Once calculated, the paid corporation tax is determined based on these taxable profits. We have a super handy Corporation tax calculator you can use to further help guide you.
What if you could decrease this tax liability? Indeed, contractors can claim expenses to reduce their Corporation Tax. The aim for every contractor should be to ensure they can claim all business expenses that they are entitled to to ensure their corporation tax is kept as low as possible.
Corporation tax is a liability that is faced by your limited company, and so it is paid directly from the company bank account. It is calculated once per year in your annual accounts and must be paid nine months and one day after your company year end has finished.
Some countries require company year ends to be on a specific date, but that is not the case in the UK. Across our entire client base, our clients company year ends are fairly evenly distributed across all calendar months.
So for example, if your company year-end is 30 Nov 2023, then your corporation tax for that period must be paid to the HMRC by 01 Sep 2024.
The Role of Income Tax in a Contractor’s Life
Tax doesn’t end at Corporation Tax. Income Tax is another significant player in the UK tax landscape. However, for UK contractors, income tax features rarely. In our section below called “Salary vs. Dividend Income: What’s Best for You?” you will see the reason for this. But lets cover this tax off anyway.
The personal allowance is currently set at £12,570 for the tax year 2023/24. This is the amount that can be earned as salary before having to pay income tax. If you set your annual salary above this amount, then income tax will start to become due.
Income tax is calculated through your company payroll. We strongly encourage all of our clients to register for PAYE (Pay As You Earn) with the HMRC so they can draw at least some salary from their business. The benefit of drawing a salary is it is fully tax deductible for corporation tax, however the downsides are it starts to accrue income tax and National Insurance. As I mentioned previously, we will cover this in more detail below.
If you are however running a salary through your business that exceeds the personal allowance, then every month your liability to income tax is calculated and reported to the HMRC through the usual monthly payroll filings (these filings are required by all PAYE registered businesses, and nearly all of our clients do this monthly. Fortunately, we have an excellent payroll software embedded into our Joy Pilot accounting software that makes this process automatic). Income tax and national insurance contributions are deducted from the contractor’s wages before they are disbursed, ensuring the employee pays tax.
Then if income tax is due, then it must be paid from your business to the HMRC once per quarter.
National Insurance: A Dual Responsibility
Next up on the tax journey is National Insurance Contributions (NICs). This form of taxation is levied on salary earnings just like income tax above. It is a compulsory contribution for individuals aged 16 or above who surpass a specific income threshold.
The way these contributions are calculated and paid depends on the contractor’s employment status. Self-employed sole traders or freelancers typically make National Insurance payments through self-assessment, while limited company contractors are required to pay Class 1 Employees National Insurance on earnings exceeding the Primary Threshold.
Obviously for our limited company clients it’s the latter option that applies, and any NIC’s due is calculated based off the gross salary that is paid to the contractor. The reporting of National Insurance and any payments that are due align with PAYE as mentioned above.
What a lot of contractors don’t realise is your limited company will pay two types of National Insurance, Employers, and Employees. Employers National Insurance is paid directly by your limited company in addition to your monthly gross salary. By contrast, employees National Insurance is deducted from your pay (so if funded by you) and paid across to the HMRC on your behalf by your business.
Navigating Value Added Tax as a Contractor
Rounding off our tax journey is Value Added Tax (VAT). This tax is imposed on the sales of businesses in the UK. Contractors are required to account for VAT on a quarterly basis and may need to register for VAT if their turnover surpasses the registration threshold.
You need to register for VAT when your business’s annual taxable turnover for the last 12 months exceeds the VAT registration threshold of £85,000, or if you expect your turnover to go over £85,000 in the next 30 days.
Just quickly, input VAT is the VAT that a limited company contractor pays on goods and services purchased for business use. Output VAT is the VAT that the contractor charges to their clients when they sell their own goods or services.
When completing a VAT return you essentially report all the output tax that you have collected and you deduct from that any input tax that you have incurred and the difference gets paid to the HMRC. In practice what this means is your business is saving the cost of the VAT on any purchases it makes.
For contractors, the Flat Rate VAT Scheme for VAT may offer some benefits over the standard VAT scheme. We cover this in more detail in the section “Choosing the Right VAT Scheme“.
Salary vs. Dividend Income: What’s Best for You?
Having navigated the world of contractor taxes, the question arises: salary or dividends, which one serves you best? This decision isn’t straightforward, as both have distinct tax implications. Salary income is liable to Pay As You Earn (PAYE) Income Tax and National Insurance deductions, while dividends are subject to dividend tax on your personal tax return, with the first £1,000 being exempt from taxation.
Choosing between salary and dividends isn’t straightforward – frequently, a mix of both proves to be the most tax-efficient strategy. However, this balance depends on a variety of factors, including the contractor’s personal circumstances, financial goals, and the specific tax considerations of their jurisdiction.
When it comes to salary, there are a few crucial elements to consider. Firstly, the impact of Income Tax and National Insurance payments can significantly influence the net take-home pay. Therefore, optimizing these elements is key to making the most out of your salary.
Pension contributions, as a part of employment costs, also deserve consideration. In most cases our contractor clients will make pension contributions directly from their limited company and bypass the usual automatic enrollment process where contributions are made through the payroll.
Dividends as an Income Stream
On the other hand, dividends present an alternative income stream for contractors. Dividends are an allocation of profits from a contractor limited company to its shareholders, often serving as an effective way to distribute earnings.
The taxation of dividends for contractors in the UK is subject to different rates, with the initial £1,000 being exempt from taxation. Beyond that threshold, dividends received are charged at a rate of 7.5% for basic rate taxpayers, with higher rates applying to higher earners (up to a maximum of 39.35%). Generally speaking, dividends bring benefits such as lower overall tax rates compared to salary and exemption from National Insurance contributions, typically leading to a higher net take-home pay.
Optimizing Your Take-Home Pay
Having a solid grasp of various aspects of contractor taxes, let’s explore ways to boost your take-home pay. This includes striking the right balance between salary and dividends, as well as making the most of your personal allowance.
Various strategies can be employed to maximize take-home pay. Strategies for this include:
- Claiming all eligible expenses
- Drawing a modest salary
- Paying dividends
- Leveraging tax-efficient perks
The Personal Allowance Sweet Spot
One of the key factors that can influence your take-home pay is your personal allowance. The current personal allowance rate for contractors in the UK is £12,570.
However, surpassing the tax-free personal allowance threshold can lead to an increase in your tax obligation, as any earnings exceeding £12,570 will be liable to income tax and national insurance. Consequently, finding the right balance in personal allowance is key to achieving maximum tax efficiency.
Striking the Right Balance
The balance between salary and dividends plays a key role in influencing your take-home pay. Receiving a minimal salary and the remainder in dividends will lead to worthwhile tax advantages, including lower total tax payments and dividend tax, making it a strategic way to pay tax efficiently.
With knowledge of the income bands where PAYE and NIC becomes payable, two tax efficient options stand out;
(1) Pay yourself a salary of £1,047.50 per month. At this rate, you will have no PAYE or employees NIC due, however there will be a small amount of employers NIC to pay (£478.86 for the year). This is the most tax efficient option.
(2) Pay yourself a salary of £758 per month. At this rate, you will have no PAYE or employees NIC or employers NIC due. There will be no payroll taxes due at all. It is not quite as tax efficient as the option above, however the reduction in admin (no need to remember to pay the employers NIC) makes this option the most popular with our clients.
IR35 Legislation: Staying Compliant
Having covered the basics, it’s time to take a VERY quick look at a more intricate topic – the IR35 legislation. This tax legislation aims to ensure that workers who are “disguised employees” pay similar levels of Income Tax and National Insurance as employees.
Falling within IR35 could potentially reduce a contractor’s net income by as much as 25% due to heightened income tax and National Insurance Contributions (NICs). Thus, it’s vital for contractors to maintain compliance and comprehend the implications of this law.
Essentially, if IR35 applies to the contract work you are undertaking, then none of the salary/dividend tax discussion above applies because all of your income will be taxed as if you were a full-time employee.
IR35 Impact on Limited Company Contractors
The IR35 legislation has a significant impact on limited company contractors. This legislation is designed to evaluate whether a contractor using a limited company is truly an independent contractor or is considered a ‘disguised’ employee for tax purposes.
We have already written several blogs articles about IR35, so just head over to them to learn more. IR35 News, Contractor status: Inside IR35, and Surviving IR35: Options if Your Client Won’t Hire Outside IR35.
Umbrella Companies and IR35
While IR35 has significant implications for limited company contractors, it does not extend to umbrella companies. Contractors engaged through an umbrella company are classified as employees and are not subject to IR35 regulations, thereby avoiding the assessment for being ‘disguised’ employees.
Most about limited company clients who find work that is inside IR35 will avoid using their limited company, and we’ll use our PAYE umbrella service instead.
We’ve journeyed through the landscape of contractor taxes, exploring the various types of taxes, the balance between salary and dividends, and have touched on the complexities of IR35 legislation.
While it may seem overwhelming at first, with the right knowledge and strategies, contractors can transform this complex terrain into a path towards financial optimization. Remember, the key to success is understanding your obligations, staying compliant, and making strategic decisions that optimize your tax efficiency.