Umbrella companies are a life saver for some contractors. They’re essentially a half-way point between being a regular employee and a fully self-employed contractor. By taking care of payroll and providing statutory benefits, umbrella companies make it easier and more practical to operate as a contractor.

Should you use an umbrella company? In truth, there are some scenarios where it’s simply not the best option. The other alternatives, like operating as a sole trader or setting up a limited company, may work better for you.

In this guide, we explore when not to use an umbrella company.

1.   Fees

The first factor to consider with umbrella companies versus going it alone is the fees. In exchange for adding you to their payroll, processing invoices and tax, and providing statutory benefits, umbrella companies take a fee out of your income each month. This is typically a fixed fee but can also be a percentage of your total invoice.

They will also make a deduction to cover the cost of employer’s national insurance -which they pay on your behalf by law.

In either case, if you’re not happy having a bit more money taken out of your income, an umbrella company is not for you. They provide important services, that save a lot of time and hassle for contractors. However, if you don’t see the value of these services, it’s worth trying the sole trader route, processing your own invoices and tax.

2.   Earnings

Another significant factor is how much you earn. That’s especially important if you want to minimise the amount of tax you pay – and maximise your take-home pay. Umbrella companies process tax through pay-as-you-earn (PAYE). That’s the standard method of tax for most full-time employees in the UK. It uses the following tax bands:

• Personal allowance on earnings up to £12,500 a year – 0% (tax free)
• Basic rate on earnings between £12,501 and £50,000 – 20%
• Higher rate on earnings between £50,0001 and £150,000 – 40%
• Additional rate on earnings over £150,000 a year – 45%

If you’re working as a sole trader, processing tax through self-assessment, you’ll pay the same rate of tax as a PAYE employee. However, if you set up a limited company, you can act as the director and sole shareholder of your company. Company profits are taxed at the corporation tax of 19% – which is fixed regardless of income. Most limited company directors pay themselves a salary of £12,500 a year through PAYE to take advantage of the tax-free allowance.

Dividends through a limited company

As well as paying yourself a salary, you can take money out of the company as a dividend. Dividends have a tax-free allowance of £2,000 and are exempt from national insurance charges. They also have lower tax rates than income tax, based on the band you fall into for income tax:

• Basic rate – 7.5%
• Higher rate – 32.5%
• Additional rate – 38.1%

Dividends will be subject to ‘double taxation’ as your company’s income will first be taxed at 19%, before the dividend is taxed as your income. However, the exemption from national insurance and increased tax-free allowance still makes this advantageous to most contractors.

Remember, you don’t have to take all your company profits out as dividends. Income can be taxed at 19% then used to invest in new equipment or training for the company.

On the flipside, limited companies need to submit accounts and corporation tax returns annually. If you don’t mind taking on the additional administrative burden and complications, this could be a better option for you.

3.   Growth

Umbrella companies are especially popular with contractors who are moving from full-time employment. They make it easy to take on contracts without any additional admin work. However, there may come a time when you want to expand your operation and take on new people.

As a sole trader or limited company, employing people for the first time is relatively straightforward. You simply need to have employers’ liability insurance, a written statement of employment and be prepared to pay them and collect their tax and national insurance contributions.

However, working through an umbrella company, you are classed as an employee. With that in mind, you can’t employ someone else and start to grow your company.

4.   Control

If you want complete, independent control over your employment, umbrella companies may not be the right choice. They offer the ‘best of both worlds’, with the freedom of self-employment without the admin. However, there are some aspects which you can’t control – such as the fees they take or the statutory benefits they provide.

Working for yourself, if you have enough money saved up, you may choose to take a lot more time off than the statutory minimum, for example. In some instances, umbrella companies may also have specific terms for leaving, meaning you can’t come and go as freely as you would want to.

Don’t forget IR35

While a limited company may seem like a favourable option – especially in terms of income – the government does have legislation in place to combat people setting up a company solely for personal financial gain. IR35 (also known as the Intermediaries Legislation) aims to stop contractors avoiding tax by working through an intermediary – where they would otherwise be an employee.

IR35 considers who has control of the worker, from their responsibilities to how they’re paid – to determine whether they are essentially an employee or a genuine limited company.

Contractors running a limited company may be penalised by IR35, meaning they would need to pay back any savings in unpaid tax. However, working through an umbrella company, you are classed as an employee, making IR35 irrelevant.