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An umbrella company is a type of ‘middleman’ company that acts as an employer for temporary workers, such as contractors, consultants, freelancers, and agency workers. For some people, it is a viable alternative to setting up a limited company or operating as a sole trader.
In this post, we’ll look at umbrella companies in more detail, outlining how they work, the types of individuals for whom they are useful, the advantages and disadvantages they offer, and how working through one compares to running your own company.
About umbrella companies
The purpose of an umbrella company is to provide continuous ‘employment’ to individuals who work on temporary contracts and/or contracts that fall inside IR35 legislation (off-payroll working rules).
They act as ‘employment intermediaries’ for payroll purposes, bridging the gap between a contractor or temporary worker and a client or recruitment agency.
This type of arrangement enables such individuals to enjoy the benefits of employment, rather than having to set up their own limited company or operate as a self-employed sole trader.
An umbrella company also provides a vehicle for sole traders and company owners to legitimately engage in contracts inside IR35 legislation, alongside the work they carry out through their own businesses.
However, umbrella companies are not responsible for finding contracts for workers – this is up to the individual. So, how do they actually work?
- When a contractor or freelancer joins an umbrella company, the company becomes the employer of the individual worker.
- The umbrella company signs a contract with the worker’s client(s) or recruitment agency and invoices them for the worker’s services.
- The client or agency pays the umbrella company directly, based on the timesheets that the worker submits to the umbrella company.
- The umbrella company then subtracts their fee and pays the worker as an employee through PAYE, deducting their Income Tax, National Insurance contributions, and pension contributions.
On or before each payday, the umbrella company will also provide payslips to each employee, detailing their income and deductions.
Essentially, the role of an umbrella company is to provide administration and payroll services to contractors and temporary workers who need or want to work through an intermediary employer.
Who would use an umbrella company?
They can be beneficial for a number of self-employed individuals and temporary workers, including:
- first-time contractors who want to get a feel for self-employment before setting up a company
- individuals who will only be contracting in the short term
- contractors who work inside IR35 legislation on one or more temporary contracts
- self-employed workers who want to minimise their administrative obligations
- contractors and freelancers who earn a relatively low daily rate and for whom setting up a company may be less cost-effective
- agency workers who want to benefit from full employment rights
Some contractors enjoy the simplicity that umbrella companies offer, as well as their ability to facilitate engaging in IR35 contracts.
On the other hand, most contractors prefer to be in complete control of their business and finances and enjoy the tax benefits of running their own company.
Am I employed or self employed if I work through an umbrella company?
If you work through an umbrella company as a contractor, consultant, freelancer, or agency worker, you will be an employee of the umbrella company.
You will be responsible for securing your own work directly with clients or through a recruitment agency, but the umbrella company will take care of invoicing clients for your services and paying you through Pay As You Earn (PAYE) as part of their payroll.
This means that you will enjoy the tax status and benefits of a regular employee, which is in contrast to individuals who trade through their own companies or as self-employed sole traders or partners in a business partnership.
Benefits of working through an umbrella company
Whilst you may be viewed as a contractor or freelancer, you will have the employment status and tax status of an employee when working through an umbrella company. This can be advantageous for a number of reasons.
1. Freedom and flexibility
Working through an umbrella company allows you to balance the freedom and flexibility of working as a contractor with the option of engaging in contracts both inside and outside IR35. This is the most significant benefit for contractors affected by IR35 rules.
2. Holiday pay and other employee benefits
You will receive continuous employee benefits whilst working on one or more temporary contracts on a short-term or long-term basis. This includes statutory annual leave (holiday pay), Statutory Sick Pay, and Maternity and Paternity Pay.
3. Less administration
An umbrella company processes your earnings through payroll and makes all necessary PAYE deductions, including Income Tax, National Insurance contributions, and Student Loan repayments.
This means that you do not have to prepare accounts, calculate your annual earnings and deductions, or file your own tax returns for HMRC for the work you do through an umbrella company.
There is also less administration to contend with in general. They will deal with your invoices, payments, payroll, and pension contributions. Additionally, you won’t have to keep company records, register for different business taxes, or make statutory filings at Companies House or HMRC.
4. Pension contributions
You will be eligible for auto-enrolment in a workplace pension scheme, allowing you to make tax-efficient pension contributions and receive employer contributions from the umbrella company.
Some umbrella companies also allow their employees to contribute towards a personal pension with salary sacrifice.
5. Other benefits
Compared to sole traders, working through an umbrella company can sometimes make it slightly easier when applying for a mortgage or personal loan. It can also make it easier to borrow more.
Agency rules do not apply to you if you work through an umbrella company.
If you are new to contracting and want to test the waters, an umbrella company can be a good way to determine whether you would like to pursue contract work in the long term.
You won’t have any unexpected tax bills for the work you do through an umbrella company, nor will you need to set aside money to pay your future tax bill at the end of the tax year.
Drawbacks of working through an umbrella company
Whilst there are certain benefits to working through an umbrella company, it is important to be aware of the disadvantages of this type of arrangement.
1. Less tax-efficient
Contracting through an umbrella company is less tax efficient than operating through your own limited company. You will pay tax at source (i.e. as soon as you are paid), rather than being able to pay your annual tax bill after the end of the tax year.
Depending on how much you earn in a year, your take-home pay may also be significantly less if you work through an umbrella company.
Whereas, if you were to operate through your own company, you could minimise your tax liability by taking some of your income as a director’s salary and the rest as dividends, which attract a lower tax rate.
You will need to pay fees to an umbrella company, which will be deducted from the day rate that your client pays to the umbrella company. These fees can be significant and will further decrease the amount of money that you take home compared to contracting through your own company.
To operate, umbrella companies rely solely on the day rates of their workers. Consequently, all of the benefits you receive through them will ultimately come from your contractor pay.
This includes your holiday pay entitlement, employers’ National Insurance, and employers’ pension contributions. So, in many cases, you are not actually benefiting from these employee ‘perks’ – you are paying for them yourself.
3. Hidden costs
The payslips of contractors who work through an umbrella company can be complex, often including hidden deductions that can add up to a significant sum over the long term.
4. Risk of non-compliance
Unfortunately, there are a lot of unscrupulous umbrella companies in operation. Some are non-compliant, which puts contractors and other workers at risk.
If you choose to work through one, do your research to ensure they are legitimate and reputable. Look for one that is an accredited member of the Freelancer and Contractor Services Association (FCSA).
Ultimately, it is your business and income at risk, so choose wisely if you decide to use an umbrella company for some or all of your work.
5. Less control and independence
Working for yourself and running your own business brings with it a great deal of control and independence. This is one of the key attractions for so many people.
However, one of the consequences of using an umbrella company is the loss of these benefits to a certain degree. You will be relying on the umbrella company to invoice your clients, collect your earnings, pay you on time, and deal with your tax affairs correctly.
How do I get paid through an umbrella company?
If you work through an umbrella company, you will receive your earnings through PAYE as part of the umbrella company’s payroll.
You will be taxed at source, meaning that the umbrella company will make all necessary deductions for HMRC through PAYE before you receive your wages.
Your earnings will be paid directly into your bank account on each payday, and you will receive a payslip outlining your income and deductions.
Do they provide holiday pay and statutory benefits?
Contractors and other workers who are employed through an umbrella company receive holiday pay and other statutory benefits, just like regular employees.
This means that you can claim Statutory Sick Pay and are entitled to Statutory Maternity/Paternity/Adoption Leave and Pay.
However, be aware that certain employee benefits, like holiday pay and employers’ pension contributions, will ultimately come from your own contractor day rate.
Can I run a company and use an umbrella company at the same time?
There is nothing to prevent you from working in both capacities at the same time. You can trade through your own limited company or as a sole trader whilst also being employed through an umbrella company for other contracts.
In such instances, you will continue to pay Corporation Tax, VAT (if applicable), and Self Assessment tax on the profit you make through your own business. And for the income you earn through an umbrella company, you will pay tax through PAYE as part of their payroll.
This is a common situation for limited company owners and sole traders who also work on one or more contracts that fall inside IR35 legislation. The earnings from such contracts must be paid and taxed at source through payroll.
Through an umbrella company, workers can engage in contracts inside and outside IR35. This is because IR35 status applies to contracts, rather than individual contractors themselves.
Setting up a company vs working through an umbrella company
An umbrella company is most useful if you are new to contracting, engage in contracts inside IR35, charge a low daily rate, or will only be contracting for a short period of time. Otherwise, the better option is set up a limited company of your own.
A limited by shares company is the most tax-efficient structure for the vast majority of contractors and many self-employed individuals. You will have far greater control over your business and income.
However, one of the downsides to be aware of is the administrative obligations you will have as a company director. You will be responsible for:
- registering your company for Corporation Tax and VAT (if applicable)
- registering yourself for Self Assessment
- preparing annual accounts for Companies House
- preparing accounts and tax returns for HMRC
- paying taxes to HMRC
- operating PAYE to process your director’s salary
- filing an annual confirmation statement with Companies House
- keeping company records and registers
- notifying Companies House about any changes to your company’s registered details
This seems like a daunting amount of work, but most people find that the significant tax benefits of running their own limited company far outweigh the inconvenience of having to deal with these admin duties.
Additionally, you always have the option of appointing an accountant to deal with your tax affairs and using a company secretary service to take care of other statutory administration tasks. For a small company, these types of services are generally very affordable.
An umbrella company is a useful employment option for some contractors and freelancers, most notably those who work inside IR35 legislation.
It may also be an appealing solution if you are new to contracting, unsure whether to pursue this type of work in the long term, or are particularly averse to the administrative tasks associated with running your own business.
Nevertheless, setting up a company and being in full control of your own business and finances is the better option for the majority of contractors and self-employed individuals.
Even if you do engage in IR35 contacts that require you to work through an umbrella company, it is usually best to limit their use to only those contracts. All other temporary contacts and work can be taken on through your own company.
There is a lot to consider, but hopefully, this post will help you to decide if an umbrella company is a suitable option for you.
If you have any questions about this topic or would like to speak to someone about setting up a company, please leave a comment below or contact our team of company formation specialists for help and advice.