ACCOUNTING AS A CONTRACTOR
When done right, you can generally see more money in your back pocket as a contractor than a permanent employee. The process involved in managing your business accounts as a contractor can be confusing, but it is vital that you understand the ins and outs to make sure that you fall on the right side of the law, as well as take home the right amount of your hard earned cash. Read on if you're a first time contractor, looking to streamline your contracting business or need a refresher on the accounting processes involved in contracting.
What’s the first step?
The first step is to decide whether you want to work through an umbrella company or set up your own limited company (self-employed contractor). An umbrella company would make managing your finances a lot easier, but a limited company would ultimately cost you less to run and would enable you to have full control over your finances.
Whilst working under an umbrella company, you wouldn’t have any of the duties involved in running your own limited company, including requirements to file tax returns or your accounts to Companies House, or working out corporate tax liabilities. Working through an umbrella company can take a lot of the administration involved in contracting away, but you would also see a less of your pay. If planning to set-up and run your own limited company, you should obtain the services of an accountant who is well versed in contractors’ limited companies as this can make this process a lot easier, but it’s worth working out the cost implications of this route compared to working through an umbrella company.
There is no 'right' option on this step, it really depends on what your goals are in contracting. Have you started contracting to make as much money as possible? Or have you made the transition because you want a better work-life balance? Thinking about your motivations will help you decide which route to take here.
What do I need to know about taxes?
One of the main reasons contractors take home more pay is the difference in taxation for permanent employees and self-employed contractors. If you're working under an umbrella company, they would deal with National Insurance contributions and other taxes for you. In this case, you would be taxed in the same way as a permanent employee as technically you would be an employee of the umbrella company.
If working through your own limited company however, you should be aware of the various taxes that apply, as well as the deadlines and processes involved in filing. The taxes can be split into ones paid through your limited company, and ones paid personally.
Firstly paid through your company, corporation tax. This is the tax companies pay on their profits each year, and is usually due 9 months and 1 day after the end of your companies’ financial year. You should register for corporation tax when setting up your limited company or within 3 months after starting your business. You can do this online via HMRC. Also make sure you keep track of what you owe throughout the year by preparing a company tax return, which should be provided to HMRC within 12 months of the end of your companies’ financial year. This can be also be completed through HMRC’s website.
As the director of a limited company, you would also need to pay tax on dividends. It's pretty common for contractors to pay themselves small 'salaries' and take home the rest of their money as dividends. This essentially means you'd be paying yourself as a director with dividends, but as an employee with a salary. This route can be more tax effective but we recommend you speak to a specialist accountant who can guide you further on this. Dividends have a £5,000 limit, after which they are taxed at a rate tied to your personal tax-free allowance. VAT registered limited companies would need to charge VAT on their invoices and account to HMRC, normally every three months, for these charges. You would also be able to claim back VAT on purchases where applicable, something which clearly shows the savings available for contractors.
Personal taxes include income tax and employees National Insurance contributions. Any salary you pay yourself as a director is subject to the normal income tax rules. This means that after your personal tax-free allowance (normally £11,000 for 16/17) your salary will be taxed at 20% until it is between £32,001 and £150,000 where it will be taxed at 40%. Any salary above £150,000 is then taxed at 45%. National Insurance contributions are also taken from the salary you've paid yourself - 12% on anything above £112 a week and 2% on anything above £827 a week.
Another benefit for self-employed contractors is the tax they can save on by using a pension. When a portion of income is invested into a pension, it does not have income tax applied and becomes an investment. It is worth considering that the basic State Pension is available to self-employed contractors who have made National Insurance contributions. To get the full State Pension you will need to have shown you have paid National Insurance (either by voluntary contributions, credits for those who are unemployed or through working) for 30 years. If eligible you may be able to go back and pay voluntary contributions for any years you are missing, due to unemployment or other mitigating factors.
Can I claim expenses?
Expenses are another way a contractor may be able to benefit over a traditional permanent employee. Expenses are available for those working under an umbrella company or their own limited company but should always be supported by a VAT receipt. There is a slight difference in the definition of an expense between limited companies and umbrella companies. Limited companies need to show that expenses have been ‘incurred wholly and exclusively for business use’ and an umbrella employee must show that the expense was ‘incurred wholly and exclusively and necessarily in performing their duties.’
Travel expenses, accommodation and materials necessarily purchased for the carrying out of duties can all be claimed as expenses by both an umbrella employee and a self-employed contractor. Self-employed contractors are entitled to many other benefits including; business mobile phones, computer costs or training costs. They are tax deductible, meaning you would not pay tax on costs incurred. The key thing to remember is the costs must be incurred for business use, or are needed to perform as per the contract.
It is important to remember that you must be able to show the receipt for an expense if requested as HMRC would consider false claims as tax avoidance. It’s recommended that you keep 6 years of receipts, as this is how far back HMRC can investigate should they do so.
What is IR35?
An important piece of legislation to consider when attempting to account as a contractor is IR35. This was introduced to prevent contractors acting as 'disguised employees.'
Employers benefit from contractors working with them as they do not have to pay National Insurance or their employer National Insurance contributions on the contractors pay, and the contractor is not entitled to employee benefits such as paid holiday and sick pay. To overcome the surge in employers circumventing the rules like this, HMRC (as Inland Revenue) introduced IR35. This sought to remove the practice by 3 'tests of employment'. These are; control (what level of control does the client have over the contractors work?), substitution (would the worker be able to send a substitute?) and mutuality of obligation (is the employer obliged to offer work, is the worker obliged to accept it?) If you are a genuine small business contractor, IR35 will not apply and you shouldn’t have to worry about getting caught out. However, if you are caught by IR35 you could owe up to 6 years of taxes, so it's worth making sure you're the right side of the legislation.
What insurance policies do I need?
Finally, you may be required by law to obtain certain types of business insurance cover. If you have any employees you will need to obtain employers liability insurance. This protects you from claims made against you by employees, and as such is not required by law if you do not have employees. Some clients require to see this insurance however and may not let you onsite until it is received, so it is worth having for this purpose.
If you travel to other business premises or receive business visitors to your trading address you must obtain public liability insurance. This will protect you against claims made against you from a member of the public or a client regarding product or premises damage. This can also protect you if you damage any property when onsite with a client, which means it's important to obtain even if you do not have clients to your trading premises.
The final insurance many of our clients require is professional indemnity insurance. This is designed to protect you against any claims made by a client regarding the work you've completed for them. Again, it is not required by law but it is sensible to purchase this. Ultimately, any claim not covered by insurance could be enough to send a small business under, so it is well worth making sure you have strong cover in place should anything happen. These insurances can be obtained from insurers such as Hiscox or Qdos Contractor.
Sources:
https://www.gov.uk/self-employed-national-insurance-rates
https://www.gov.uk/government/publications/rates-and-allowances-national-insurance-contributions
https://www.gov.uk/government/publications/rates-and-allowances-income-tax
