Someone working as a full-time employee for a particular company will no doubt be familiar with the topic of PAYE, which is income tax deducted by the employer from an employee’s salary every month and then paid over to the Inland Revenue. This is therefore literally a ‘pay as you earn’ system.
For individuals who want to sell their services there are many drawbacks to the employee-PAYE system. Not only does being a full-time employee mean having to work for a boss, it also often means inflexible working hours and not being able to deduct work-related expenses from income tax.
The two most popular alternatives to the PAYE system for individuals who prefer to work for themselves are to set up a limited company or to sign up with an umbrella company.
The limited company option does involve some paperwork and the contractor will need to appoint an accountant, but it is the most tax-efficient alternative. It also allows the contractor to deduct the widest range of expenses. Another benefit of a limited company is that it allows one to make use of the Flat Rate Vat Scheme.
The profit of the company is taxed at a fixed rate and the company owner can decide how much he or she wants to be paid in terms of salary and dividends. The company will be taxed on the balance. Having your own limited company also creates an image of professionalism that might be very useful when applying for a lucrative contract.
For smaller contractors, typically those who earn less than £20,000 per year, working through an umbrella company is often the most effective option in terms of income tax. In this case the contractor is employed by the umbrella company that is responsible for collecting outstanding amounts from the contractor’s clients. They will deduct PAYE Tax and NI as well as their fees and pay over the balance to the contractor.
The benefit for the contractor is that the umbrella company takes care of all the paperwork and that he/she can claim certain business-related expenses against income received. Take note, however, that the necessary receipts to back up such expenditures must be provided to the umbrella company.
From a business point of view there are many benefits in dealing with contractors instead of employing full-time staff. When demand is slack employees still have to be paid, regardless of whether there is enough work to keep them busy or not. Employees usually want perks, such as car allowances, pension funds and medical aid schemes. They also want paid leave and bonuses. None of these apply when dealing with contractors.
In many cases the preferable option is to employ people on a contract basis instead of employing them full-time. This is perfect for one-off projects, e.g. upgrading the company’s software systems, the yearly stocktaking, etc.
When a certain position doesn’t warrant a full-time employee, it is also possible to appoint a part-time staff member. A business could, for example, employ someone for a few days every month to do the monthly bank reconciliation.