Umbrella companies are a great option for contractors who want to keep things simple. They take the administrative burden of invoicing, payroll and tax off your plate, giving you a final sum of ‘take home pay’ every month, or after each job.

Eventually, however, many contractors make the switch from an umbrella company to becoming a limited company. Generally, it’s because of reduced taxation – and higher income as a result.

But when is the right time to make the switch? And are you ready? Read on as Umbrella Broker takes a look at the transition from umbrella to limited company.

The best fit for you

Working for yourself isn’t a case of one size fits all. It’s important to find the best way of doing things, especially when you’re starting out. Most self-employed professionals begin as sole traders, which is the simplest way to effectively run a business – without any of the registration fees.

As things become more complex, many contractors make the move to an umbrella company. These firms take on contractors as employees, taking payments and paying tax on their behalf while paying out income monthly or on a job-by-job basis. This is something of a hassle-free option for contractors.

However, as business begins to grow and more opportunities arise, it may become more suitable to set up a limited company. This changes how you’re taxed and can increase your income as a result. Unfortunately, it’s easier said than done, so it’s important not to dive in too soon.

Introducing the umbrella company

Umbrella companies are all about simplicity. Getting set up is refreshingly simple. You just need to sign a contract with an umbrella company, who will contract your services to other businesses. You don’t have to actually set up a company and there’s minimal administration going forward

Day to day, umbrella companies take care of invoicing, payroll and taxation. In many cases, they even source contracts for you so you don’t need to market yourself and network. Sometimes, it’s necessary to find your own work and you may have to review your contract with the umbrella company occasionally. However, by and large, you can focus on your job and whatever you choose to do outside of work.

Drawbacks of umbrella companies

It’s not all advantageous though. This minimal responsibility is matched with a reduced level of control. Umbrella companies determine how you are paid and taxed for sick days, holidays and maternity or paternity leave.

Using an umbrella company also means your tax is paid through pay as you earn (PAYE). This is the system used by permanent employees across the UK, and on the plus side it is a lot simpler as this is taken care of by the umbrella company. So, less admin time on the accounts. However, you can’t take advantages of any of the tax benefits that come with having a limited company.

Finally, you will need to pay a small fee to work through an umbrella company. This is typically a fair amount, but it does mean your pay will be reduced to around the 70% mark when combined with tax deductions. In most cases, this will still be significantly better than what you would have earnt in permanent employment. And with a steady stream of contracts and less time hunting for new work, you can easily offset the fees.

What about limited companies?

Limited companies are a tax-efficient alternative for contractors, allowing them to maximise their take home pay. As a contractor, you become the director of your company, as well as the sole shareholder. This allows you to claim numerous extra expenses as well as drawing some of your funds out as a dividend, which is subject to far less tax than the PAYE rate.

Needless to say, limited companies are financially beneficial for contractors. As mentioned, working through an umbrella company, you can expect to take home around 70% of your earnings. In contrast, a limited company will typically provide over 80% of your earnings as take-home pay.

Limited company drawbacks

There are some downsides to limited company ownership. First of all, you will need to set up the business. This requires choosing a name and submitting your details to Companies House either online or on paper. This small step is well worth it considering the financial benefit in the long term.

When switching from umbrella to limited, you also have to once again take on the administrative burden of invoicing and taxation. You’re completely responsible for your finances – and that of your company – so you have to chase clients for payments and make sure everything is spot on for tax.

Fortunately, accounting services can reduce the burden of these tasks, either by assisting or taking them on completely. You may find that the price of professional accounting assistance is more than covered by the financial benefit of running a limited company.

Time to switch

The extra control of a limited company versus working through an umbrella can be useful as a contractor. If things go wrong or you’re expecting a lack of work for the foreseeable future, it’s much easier to prepare your finances and adapt to the changing situation.

If you’re working through an umbrella company and you’re ready to take on the challenges explained above, it’s time to start setting up your limited company. Be sure to inform any existing clients about your plans to set up as a limited company as well as any service providers or suppliers.

Following this, set up a business bank account and inform HMRC of your changed status. You will need to register for corporation tax within 3 months of beginning to trade and register for VAT through your company. To pay yourself a director’s salary, you’ll also need to register as an employer with HMRC.