Contractors, freelancers and consultants. These terms are used frequently in the world of company formation, but what do they actually mean? It’s particularly confusing because these labels are often used interchangeably when discussing self-employment, but there are significant differences between all of them.
Generally, the role of a consultant is to advise or consult. These individuals work in a variety of specialist industries and provide professional, expert advice to other people about how to improve their lives or businesses.
Contractors and freelancers
Contractors and freelancers, on the other hand, are usually hired by individuals and other businesses to perform specific types of work on their behalf. This could be on a one-off basis or as part of an ongoing or recurring service.
We’ll take a closer look at each of these roles in turn and try to shed some light on who does what. This might help you figure out what to actually call yourself or how to set up a new small business.
A contractor is an individual who carries out work for other people or businesses in return for a pre-agreed hourly rate or set fee under a contract for services. This differs from the purely advisory role of a consultant.
Contractors are usually professional industry experts, but extensive skill sets and masses of experience are not always essential. The flexible nature of using contractors is sometimes more appealing to clients who simply do not want or need to hire someone on a permanent basis.
Contractors are hired for a fixed period of time to carry out whatever work is required by the client. Due to the temporary nature of this arrangement, the client is not required to provide any employee benefits or guarantee further work. For these reasons, many contractors are able to negotiate very high rates for their services.
What types of work do contractors carry out?
The types of industries in which contractors commonly operate include:
- IT maintenance and support
- Building services and construction
- Gardening and landscaping
- Plumbing and electrical services
- Carpentry and joinery
- Painting and decorating
- Cleaning services
- Property maintenance
- Security Services
- Independent audit services
Contractors usually work on a full time basis for a fixed period, so they tend to work on one project at a time. Due to the nature of their work and the types of industries in which they operate, it is common for contractors to carry out the majority of work at their clients’ premises.
A contractor will usually operate as a sole trader or set up a limited company through which they will offer their services, but they can also get fixed-term contract work through recruitment agencies. A limited company is the better choice for contractors who take on high value contracts or carry out work that has the potential to lead to liability claims. As a sole trader, the contractor is held personally liable if anything goes wrong.
What is the difference between a contractor and a subcontractor?
Contractors and subcontractors are not the same. A contractor provides agreed services to a client for a set fee under a contract for services. A subcontractor provides contract services to a contractor. For example:
A construction company (the contractor) is hired to build new premises for a client. The contractor hires an electrician and plumber (subcontractors) to fulfil certain parts of the building project, but only for the duration of that project. The contractor is responsible for hiring and paying the subcontractors, thus he is ultimately responsible to the client for any work carried out by the subcontractors.
A consultant is essentially a professional advisor who works as an independent specialist in a specific field. They use their experience, expert knowledge and niche skills to offer professional advice to other people or businesses in return for a fee.
Typically, the role of a consultant is to solve problems by assessing a current situation. They provide outside perspective and offer objective advice and/or make recommendations for improvements based upon their findings. The client will usually implement changes or recommendations themselves. The consultant is not responsible for carrying out the changes, nor are they usually accountable for the outcome of their recommendations.
The UK consulting industry is currently worth approximately £9 billion (Source: The Management Consultancies Association). Whilst the term ‘consulting’ is increasingly associated with business and management services, there are many different advisory disciplines in which consultants specialise, including:
- Financial Advisory Services
- Operations Management
- Technology (IT) Consulting
- Planning and Strategy
- Human Resources
- Branding and Marketing
- Political or Public Affairs
- Lifestyle and Wellbeing
- Personal Development
- Health and Fitness
- Animal Behaviour
- Child Behaviour
- Interior Design
- Environmental Compliance
Consultants are held in high regard because they are viewed as the most knowledgeable people in their respective fields. As a consultant, you may be able to charge significant fees to your clients for your advisory services, if you have extensive knowledge and experience to act in such a capacity. This is not a role that you can just take on without the requisite skills. It will take time to build your knowledge base and reputation, and you will have to continuously develop your expertise to keep up with emerging theories, strategies and industry changes.
Freelancers are flexible workers who provide services to several clients at the same time on a short-term or long-term basis for a pre-agreed hourly rate or fixed fee. More often than not, they don’t work from their clients’ premises. They have the freedom to carry out their work from anywhere they please and they communicate with clients via email or by telephone.
A freelancer is usually self employed as a sole trader or they work through their own limited company. Some freelancers may also be employed full time and carry out self-employed work on the side to earn additional income.
Typically, freelancers work as media and creative industry professionals, in the following types of roles:
- Graphic designers
- Website designers and developers
- Actors and musicians
- Filmmakers and videographers
- Marketing coordinators
- Social media experts
- Mobile developers
- Search Engine Optimisation (SEO) specialists
- Sound and lighting engineers
Depending on your skills and level of up-to-date expert knowledge, you may be able to offer consultancy services as a freelancer or contractor as part of your client services. Even if you do not charge your clients extra for your advisory services at first, it is a great way to expand your portfolio and progress into consultancy work on a full-time basis. Keeping yourself relevant is one of the most effective ways to ensure a successful career in a competitive field and obtain sufficient work across your client base at all times.
Setting up as a consultant, contractor or freelancer
You can get work in any of these types of roles through recruitment agencies, which means you can be paid and taxed through Pay As You Earn (PAYE). This is something you could do in addition to a full-time job as an employee if you require additional income or wish to build on your experience and move toward self-employment.
However, it is more common for consultants, contractors and freelancers to operate as self-employed sole traders or via their own limited companies. By doing so, you will be responsible for your own taxes, National Insurance and accounting, but your professional image and desirability will be greater and you may be able to save a considerable amount of tax. You can still source work through a recruitment agency even if you’re self-employed.
Benefits of company formation for contractors, consultants and freelancers
1. Legal compliance
- Safeguards against Intermediaries (IR35) Legislation
- Protects against Managed Service Company (MSC) Legislation
- Free from Agency Worker Regulations
2. No intermediary or 3rd party umbrella costs
When you work as a contractor through a large intermediary organisation, they plan and assign your workload, pay you a salary and maintain your records and accounts. This is great in some respects, but there’s not a great deal of flexibility or control.
If you set up a limited company, you will have much greater control and flexibility because you will be employed by your own company. This will give you the freedom to organise your own affairs, choose your workload and decide when to pay yourself. You will also be responsible for maintaining your own records and accounts, but you can appoint an accountant to do these things for you.
3. Financial planning and Tax efficiency
A limited company structure offers more flexibility for paying yourself tax efficiently. As a self-employed contractor or freelancer, your net profit is liable for Income Tax and National Insurance in the financial year it is earned. But as a company director and shareholder, you have the option of deferring tax by leaving some of your profits in the business.
These reserves can be beneficial for a number of reasons:
- You may wish to keep your salary and dividend payments below the higher tax rate threshold.
- You can create a Director’s Loan Account to remove funds without facing any tax liabilities.
- You will be in a position to react efficiently to any significant changes to the tax system.
You can also minimise your personal tax by taking most of your income as dividends, rather than paying yourself a huge salary. These dividends are paid from profits after the company has paid 19% corporation tax. You will then only pay personal tax on dividends above £2,000.
Provided you have no other significant source of income, the best option is to pay yourself a director’s salary up to the NIC Primary Threshold (£9,504/year for 2020-21) and then take additional income by paying yourself dividends as a shareholder.
Tax rates on dividends are always lower than Income Tax rates for salaries, even if the amount of the dividend exceeds the 45% Income Tax threshold. Dividends are tax-free up to £2,000, then the following tax rates are applied (after deduction of £12,500 Personal Allowance) as follows:
- 7.5% on income up to £50,000
- 32.5% between £50,001 – £150,000
- 37.5% above £150,000
Example: Limited Company vs. Self-employed Contractor
You pay yourself a salary of £9,504 and gross dividends of £40,496. This means you will receive a gross annual income of £50,000.
There is no tax on the salary, the first £2,000 of dividends are tax free, and you have the balance of the standard tax-free personal allowance, which is currently £12,500. After this, you will pay 7.5% tax on the balance of dividends up to the £50,000 threshold.
You are taxed on £35,500 net dividends, which is the taxable sum remaining after the deduction of your £12,500 tax-free Personal Allowance and £2,000 tax-free dividends.
Tax on dividends is £2,662. Total personal income after deductions will be £47,338.
Your sole trader business generates annual profits of £50,000.
After deduction of your £12,500 Personal Allowance, you will pay 20% Income Tax on profits up to £50,000. Any profits between £50,001 and £150,000 will attract Income Tax at 40%.
You will pay £7,300 of Income Tax and £3,714 in NI Contributions.
This means you will receive a total annual income of £38,986 after tax.
However, do remember that no other tax will have been payable on your business profits before you pay yourself. A company, however, will have paid 19% Corporation Tax on profits before dividends are taken.
How to register as a sole trader
To set up as a sole trader, you must register for Self Assessment with HMRC. You can do this online in just a few minutes, it is very simple. Thereafter, you must keep accurate records of your income and expenditure, retain invoices and receipts to support these figures, submit an annual Self Assessment tax return and pay your Income Tax and National Insurance directly to HMRC every year.
This is an ideal structure if you are just starting out as a freelancer providing low risk services to only a few clients. As you increase your client base and annual income, you should consider setting up a limited company to take advantage of the potential tax saving opportunities.
How to set up a limited company
To set up a limited company, you will have to register your business with Companies House. This process is known as company formation or company incorporation. If you choose to register a limited company, your business will be recognised as a separate entity in the eyes of the law, which means you will enjoy reduced personal liability if your business runs into financial difficulty or you are sued by a client.
This is a more desirable option for many self-employed individuals, especially if they are dealing with high-value contracts or client equipment, or their line of work has the potential to cause harm or damage to other people or property. If anything goes wrong, your personal finances are protected through your limited company; however, as a sole trader, this is not the case. You are liable to pay damages and compensation from your own pocket.
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