If you’re reading this then you’ve just made your first brave step into the world of self-employment.

Leaving a secure job for a contract role can be daunting at first but you’re not alone. Every month thousands of highly qualified (and rational) employees leave their employed roles for the flexibility and financial rewards of contracting.

Contracting isn’t a short term fad, it’s a growing industry that’s thriving in a world where employee employer relationships are growing increasingly fickle.

For many, the prospect of a financial boost, coupled with more control over their ultimate career goes hand in hand with the inevitable anchors that come with starting a family. Whereas once many could work every hour possible, families and lifestyles now get in the way and a more focused working pattern of less hours and more income is needed.

With undefined working hours, unlimited holidays and zero management scrutiny, contracting not only fits the bill, it smashes it out the park.

But of course you know this, so with an abundance of things to get in order before you can start your contract where does a new contractor start?

Understanding IR35, the contractor tax

Contracting didn’t used to be the thriving industry it is now. Once upon a time it was an ad hoc way for people to earn some extra cash in their spare time. Born out of freelancing (frequent short term contracts with multiple clients), contracting was for many the medium term (3 months plus) equivalent to having a second job that actually paid better than the first.

Over time, many contractors realised they could earn more by contracting that in their equivalent employed roles, but this wasn’t the only reason for contracting becoming the powerhouse that it is today.

Contracting is thriving because it’s financially beneficial to the client too. There’s multiple reasons for this from Employers National Insurance (ENI) benefits, to the lack of pension contributions and lack of a long term commitment. While HMRC doesn’t particularly have an issue with companies not employing staff for the long term, it did have an issue with the drop in ENI contributions that resulted from a switch from employed to contracting, particularly if the switch was done just to benefit the contractor and client.

As a result HMRC and the government introduced legislation that we now know as IR35. Over the years this legislation has undergone several iterations. Starting out as a rather weak piece of legislation that tackled workers that left full time employment on a Friday and returned to the same workplace as a contractor on a Monday, in April 2017 a more beefed up IR35 changed the contractor landscape for ever.

While it had been previously up to the contractor to decide if their contract was subject to IR35 (and account for their taxes accordingly), from April 2017 for those contractors working in the public sector, the decision and ultimate tax liability with respect to IR35 compliance was left up to the client. As a result swathes of public sector clients declared their contractors subject to IR35 prompting en masse transfers to PAYE and umbrella company payment programs.

What are your invoicing and payment options?

If you’re caught by IR35 then your options are limited to either a PAYE limited company (which makes having the limited company largely pointless), agency PAYE or an umbrella company.

However, in the event that you’re not caught by IR35, then you have three main self-employment options available to you.

As a contractor, you’ll be able to invoice your client as:

  • A sole trader
  • A limited company
  • Through an umbrella company

Each has their own particular way to work out your tax payments and their own rules about what expenses you can and can’t claim.

For most, operating as a sole trader is quickly dismissed as while it’s relatively tax efficient, you’ll need to pay some of your taxes on account a year in advance. For many this is a cash flow nightmare.

This leaves two real options, which combined about for around 99% of contractors on the market today; an umbrella company or a limited company.

Both have their respective benefits and weaknesses but here’s a short summary of limited vs umbrella:

  • Limited company– marginally more tax efficient (recent tax changes have curbed the tax efficiencies on offer to contractors), complete control for the contractor but with more paperwork. Great for those with long term contracts and high non-recoverable expenses.
  • Umbrella company – a low hassle way to contract that provides you with a payslip and lower fees than a limited company. Great for those unsure about the length of their contracting career, with low expenses or anyone that doesn’t want the tax headache that comes with the other routes.

Don’t forget that your choice will have implications on things like insurance

As a contractor you’re legally required to take out professional indemnity insurance to cover the event that your work causes harm to your client or their customers. Most clients or agencies will also require you to also take out public liability insurance to cover you in the vent in the course of fulfilling your work you cause someone harm or loss too.

Depending upon your choice of sole trader, limited company or umbrella, you will need to either pay for your insurances out of your own pocket or have it provided for free (by your umbrella).

So you’re leaving full time employment, what happens to your benefits?

This question entirely depends on your choice of invoicing method, however for most the only way to maintain some continuity with respect to their employed benefits is to choose an umbrella company.

While the first umbrellas were designed simply to employ contractors for the purposes of providing them with insurance and processing their payroll, with an abundance of umbrellas on the market today, most respectable umbrellas now offer employee benefit schemes such as perkbox.

While most of these schemes are designed to provide exclusive discounts at stores such as M&S or Ikea, some offer great little perks such as free coffee from café Nero.

In addition to employee benefits, compared to working through a limited company, with an umbrella you’ll also be able to benefit from statutory benefits such as holiday, maternity and sick pay.

But the benefits offered by your employer aren’t the only thing you will qualify for by working through an umbrella. As you’ll be classed as an employee you’ll still be able to claim working benefits such as the marriage allowance or childcare vouchers (soon to be childcare payments).

Finally then, regardless of your employed status you’ll still be able to contribute to your pension as a contractor. While as a sole trader or company director you’ll be able to offset your contributions against tax, as an employee of an umbrella your contributions will work just as they do now with your employer.

When you join your chosen umbrella, you’ll automatically be enrolled into their pension scheme and will be given the choice of which contributions to make. Alternatively you will also be able to opt out of the pension scheme if you’d prefer to invest your money into something else like property.