Choosing a Business Structure
If you're starting out on your own for the first time you need to make a decision about the legal structure that your business will use.
Essentially, you have a choice of three options: being a sole trader, using the services of a so-called umbrella company, or starting up your own limited company. We'll discuss each of these options in turn below.
We won't discuss managed service companies - also known as composite companies - where another company manages a limited company on your behalf. These were effectively outlawed under changes introduced in the 2007 Budget.
A key question when deciding which structure to use is related to a piece of legislation called IR35 - which means if you are effectively employed by your clients in all but name, you will have to pay Income Tax and National Insurance at similar rates to an employee. This makes some of the options described below much less advantageous from a tax point of view. The rules for ascertaining what is 'employment' and what is 'self-employment' are not always as obvious as you might think - a good accountant will help here - but at the end of the day, you'll probably know yourself whether you are pretty much an employee on a specific contract, and in any event honesty is the best policy, right?
Being a sole trader is by far the simplest option, involving the minimum paperwork and complexity. You just need to let HMRC know you are now self-employed (by calling the Newly Self-Employed Helpline on 08459 15 45 15 or filling in a Form CWF1) and start paying Class 2 National Insurance contributions (£2.10 a week at the time of writing)
You will need to keep records of the income you receive and expenses you incur, and then complete the Self Employment Section of the Self-Assessment Income Tax form the Revenue will send you.
There are some downsides, some of which are:
- You have unlimited liability for business debts you run up, such as bank loans and amounts you owe creditors. For many FreeAgents this won't be a problem, since you won't be borrowing money from banks or suppliers to get your business going.
- You are likely to have problems dealing with some clients and agencies, who insist on dealing with limited companies. This is especially true for IT Contractors who have been targeted by HMRC.
- You will end up paying the most tax, since all your income will be subject to Income Tax and National Insurance.
Using an Umbrella Company
With an umbrella company, you are an employee of that company. Your clients contract with the umbrella company, and that company will issue and process invoices on your behalf. They then deduct their fees and the appropriate Pay-As-You-Earn (PAYE) tax and National Insurance Contributions, and pay you the rest as salary. You can claim certain expenses - most umbrella companies will have dispensations from the HMRC which will allow you to reclaim some expenses without filling out too many forms, as long as you really have incurred them.
Clearly, there will be no tax advantage from working this way, but it is really intended for IT contractors who would fall within the IR35 rules anyway, and are looking for a way of contracting which keeps clients happy and paperwork to a minimum.
Setting up a Limited Company
As a general rule, running your own limited company is the most tax efficient way of being a FreeAgent, but it is also the most complex.
The tax advantages come from the way you can extract profits from the company in the form of dividends which you, as the only shareholder, will receive in their entirety. Normally you would plan to pay yourself a minimal level of salary too, on which tax and NI is payable, to ensure you retain your entitlement to NI-related benefits. But since there is no NI due on dividends, and they themselves are subject to tax at a slightly lower rate than normal, you can expect to pay several thousand pounds less in tax each year if you have a reasonable turnover. Of course life is never quite as black and white as this and the services of a professional accountant who can advise you how to legally pay the minimum amount of tax is an absolute must.
There is a substantial administrative burden involved in all of this - setting up the company and payroll, sending annual accounts and returns to Companies House, calculating and paying Corporation Tax, calculating what dividends you can pay yourself, and so on.
However there are plenty of accountants who can help with all of this, and services like our very own FreeAgent can help keep the time spent - and hence your money - on all of this to a minimum.
If you fall within the IR35 rules, the advantages are much reduced - the Revenue will expect you to pay tax and NI on your income as if you were an employee. This need no prevent you from enjoying certain tax benefits but again, you should consult with a professional accountant.
- Spreadsheets versus FreeAgent: an accountant’s point of view
- Autumn Statement 2016: contractors feel the impact
- Autumn Statement 2016: how could the new chancellor show he cares about small businesses?
- FreeAgent is now a public company!
- 3 spreadsheet horror stories from the world of work