Umbrella companies make it easier for contractors to work for themselves. That’s something you’ll likely hear a lot if you’re a contractor. But how does an umbrella company work? Needless to say, it’s important to understand how umbrella companies operate before you sign up.

Read on as we clear things up when it comes to the ins and outs of umbrella companies…

What is an umbrella company?

In simple terms, an umbrella company is an organisation set up to help contractors fulfill short-term and medium-term contracts. They take on numerous contractors, who all complete their own duties for agencies or clients. In that sense, the company is an ‘umbrella’ over a number of different contractors, all working for themselves.

How do umbrella companies operate?

Umbrella companies work by acting on behalf of contractors. Contractors are taken on as employees of the umbrella company and receive the same benefits of any permanent employee at a regular company. However, through an umbrella company, these benefits are essentially a service they provide to contractors.

The umbrella company will invoice clients or agencies for contractors. Process their pay for tax and national insurance and provide statutory benefits like sick pay, maternity pay, holiday pay and a workplace pension. In return, contractors have to pay a fixed monthly fee. In some cases, this fee will be charged weekly, or could even be a percentage of the invoiced sum rather than a fixed amount.

Umbrella company fees are deducted before income is processed for tax, so they effectively cost contractors a bit less. Paying £100 before tax, for instance, only costs you around £70 in terms of what you would have taken home after tax. That’s assuming that it would have been subject to 20% basic rate income tax and 12% national insurance.

How does umbrella pay work?

Pay through an umbrella company is a bit like working through a recruitment agency. Contractors will notify their umbrella company of the time they’ve spent working on a given contract, usually by filling in a timesheet. This will be completed weekly or monthly, depending on what’s been pre-agreed with your umbrella company. The umbrella will then raise an invoice with the client or agency you’re working for, based on the hours you’ve worked.

The agency or client will pay your umbrella company, who will then deduct their fees before processing it for tax and national insurance. In short, that means calculating the correct amount due based on your income (minus their fees) and sending it to HMRC. After that, the umbrella company will pay the remaining take home pay to the contractor.

How umbrella companies affect tax

Some options available to contractors affect the way they’re taxed. If you set up your own limited company, for instance, you can pay yourself a salary that only incurs a small amount of tax and then dividends as a director of the company.

However, through an umbrella company, contractors are taxed through pay-as-you-earn (PAYE) taxation. That’s the most common form of tax, through which all UK employees are taxed. It’s also the same tax system used for self-assessment, which applies to any contractors who want to operate as a sole trader.

The main difference when working through an umbrella company, is that you’ll have to pay Employers’ National Insurance (ENI). This is usually paid by employers on behalf of their employees. To keep umbrella company processing fees low, they will usually deduct the cost of ENI from the gross amount paid by your client or agency.

Do umbrella companies operate within IR35?

IR35 – or the Intermediaries Legislation – was introduced in 2000 and updated in 2017 to crack down on contractors operating through intermediaries. More specifically, the government took issue with contractors setting up limited companies solely to avoid paying national insurance and PAYE tax.

It aims to distinguish between workers, operating ‘inside IR35’, and genuine companies operating ‘outside IR35’. That includes a range of criteria:

  • Who is in charge of the worker, their responsibilities and the terms of work?
  • How are they paid?
  • Does their work include expenses or benefits?

Workers who are found to be operating inside IR35 through a limited company will need to pay more tax than usual. Despite the limited company being invoiced, they will need to process the sum as personal income, deducting income tax and national insurance. They could be penalised and forced to pay back any difference in tax.

Despite also being classed as an intermediary, umbrella companies are rarely affected by IR35. Because they employ contractors, process their pay and provide statutory benefits, they’re much closer to an employer – with contractors much closer to employees.

Finding the right umbrella company

Once you know how an umbrella company works and operates, there’s nothing stopping you signing up and working through one. However, not all umbrella companies are the same. There are a number of factors to consider when comparing umbrella companies, the first of which is fees.

Since it became a legal requirement for umbrellas to offer statutory benefits to workers, fees are the biggest way they differ from one another. It’s also best to check what’s included in the fees, as some providers may charge extra for things like insurance or expenses processing.

On top of that, check the umbrella company’s experience and reputation. Search for reviews online to make sure other contractors have had a positive experience with them. There’s no point signing up if you’ll probably end up joining the queue to give them a one-star review.

If you want to take the legwork out of finding an umbrella company, try out an umbrella company comparison site. Enter your details and estimated monthly income to see a full payslip and income breakdown from several reputable umbrellas.