Should contractors work through an Umbrella or through their own Limited Company? True, there are specific times when you’d consider an Umbrella more beneficial. But when it comes to applying for a mortgage, Limited is always better.
As a Limited Company owner, you’ve taken the time to create a tangible business. Thus, you’re displaying intent, a long term commitment, in a lender’s eyes. Moreover, there’s no more tax-efficient way to contract than through a limited company.
We’re not talking small change here, either. If you’re earning £30k+ a year, limited company deductions far outweigh Umbrella fees.
These savings will reflect in what lenders use to work out how much you can afford to borrow. The more income at your disposal, the greater the potential mortgage you can borrow.
What are the key differences between Umbrellas and Ltd Companies?
As a rule, Limited Company contractors retain more of their income than Umbrella ’employees’. Nine out of ten independent professionals would be better off working this way.
But in reality, nothing like 90% of contractors go the Limited Company route. They’re missing out, big time.
Through an Umbrella, you’re availed of far fewer tax breaks than limited company owners.
Yes, Umbrellas claim expenses on your behalf that you couldn’t as a direct employee. And they’ll process your timesheet and work out your tax and NICs after expenses. But, yes, they’ll deduct a fee for the privilege.
Even then, your claimable expenses amount to nothing like those through your own business.
There’s also the flat rate VAT system to consider as a limited company contractor. If you qualify, you get to retain some of the VAT you receive.
How does National Insurance work, then?
Either way you work, you’re subject to both Employees’ and Employer’s NICs. But here’s where the gulf lies between the two ways of working.
The best way to prove the vast difference is with an example. So, let’s say you’re a contractor, working through your limited company.
Every week, you pay yourself a typical salary of £153 (based on 2014/15 taxation). The rest of your earnings you draw down in dividends. You can pay yourself so little as director’s earnings are outside minimum wage classification. Why you’d choose to do that we’ll come to in a minute.
As either a permanent or umbrella employee, you wouldn’t have this flexibility. The majority of your earnings would be subject to PAYE and associated deductions.
This is where limited company contractors win hands down every time.
Those dividends you draw do not get included in your National Insurance Contribution calculation. That means you can reduce how much NICs you pay by increasing your dividends.
Thus, the amount of tax you save compared to umbrella contractors is eye-watering.
Agencies tell me to go through an Umbrella, but not to worry: it’s easy
Okay. First things first. An agency cannot make you go through an Umbrella Company. They may push you towards one, but there maybe an underlying reason.
Some agencies do get a kickback for putting business an Umbrella Company’s way. In effect, they earn off you, they earn from your new ’employer’.
They’ll tell you it’s only business. You make up your own mind. But you have the right to a contract whether you’re a limited company owner or sole trader. Whether you get that contract by standing firm is questionable. The ball’s in their court.
They are right about one thing, though. An Umbrella company set up is much more straightforward for you than manning your own ship. But, your sacrifice for the want of an easy life is great.
If you’re looking for a stop-gap or are between roles, for example, is setting up a limited company yourself worth the hassle? Debatable, at best.
If you’re hoping to build a successful contractor business, then yes. Go, incorporate your limited company. Hire an accountant. Get your business stationery ordered and marketing organised. You’ll be a great deal better off in the long run for it.
Are Umbrellas Dodgier than Limited Companies?
Without the right guidance, you can sail too close to the wind either way you operate. With your limited company, a contractor-savvy accountant will see you right.
While most UK-based Umbrella companies understand IR35, the tide’s changing. Following December’s Autumn Statement, they face a double-edged challenge.
The tax man invited interested parties to look at tax relief for temporary workers. In particular, those contracting for “employment intermediaries such as ‘umbrella companies'”.
Whilst the Chancellor highlighted travel expenses in December, the proposals he asked may open a whole new can of worms, who knows? Tax avoidance and employment rights are almost certain to be on the agenda.
We know that undisclosed specific schemes are on the tax man’s radar, too. So, yes; expect investigations into offshore trusts to resurface.
Plus, HMRC even has more budget to strengthen its DOTAS task force. That means the enforcement of the Disclosure of Tax Avoidance Schemes legislation will tighten.
The main problem Umbrellas will face is their generic accounting methods. As a contractor, you offer a unique service or skill set. It’s hard to imagine a one-size-fits-all system for high earners, such as IT Contractors.
A bespoke accountant will look at what’s best for you, your circumstances, your business.
Their knowledge of limited company structures will help you reduce your tax liability. But they’ll do it in a way that best proves you’re not a disguised employee.
If the tax man sees you’re operating outside IR35, they’re less apt to investigate. Don’t just take our word for that, though. Every contractor should undertake an IR35 audit. Ignorance is not a defence you want to take to court.
An accountant – don’t they cost a fortune?
So, we’ve used that dreaded word: accountant. Many contractors choose the Umbrella route to avoid having to prepare their own accounts. That’s fair comment, but it’s somewhat missing the point.
Most contractor accountants charge less per year than a typical Umbrella deducts in fees.
Another get-out clause is facing up to the challenge of running the actual business. All that paperwork when you’ve got to concentrate on continuity, learning and marketing? That’s besides actually carrying out your service.
Yes, a contractor-savvy accountant can carry some of the burden. By showing you save further savings, they’re doing their bit to build the relationship. Use it to your advantage.
It could save you thousands of pounds every year between now and when you retire.
But there’s no easy way of soft-soaping the bottom line. If you want the ultimate reward, you’ve got to carry the can at least part of the way to the finish line.
Okay. If you’re testing the waters of contracting, you may want to try an Umbrella first. That’s understandable. You’ll earn on a PAYE basis. You won’t have to employ an accountant.
But if you’re earning over £30k per annum, think twice. You’d be better off creating your limited company. If you like contracting but not accounting? Then entrust your accounts to a responsible third party. It will pay dividends in the long term.
What mortgage brokers can do for you, whichever way you work
As an Umbrella employee, you can still get a mortgage based on your contract rate. The options we have, though, are far fewer and a lot less flexible.
Yes, lenders will still assess you on your annualised contract rate. But there are restrictions.
The first is that you must work for a UK-based Umbrella company. Those dreamed up offshore trusts and schemes may squeak past IR35. But that way of operating won’t sit easy with a mortgage underwriter.
A lender may also choose to write to your agency to confirm your income. This route often involves determining your net earnings. Notice the word ‘net’, not gross, contract earnings here.
Compare that scenario to contracting through your own limited company.
Say you’ve traded under your own steam for three or four years. You can access mortgages based on your contract OR on your limited company accounts.
This flexibility gives you and your broker options. You can access self-employed mortgages (full-status, based on accounts) and contractor mortgages, putting you on par with permies.
Using a mortgage underwriter who ‘gets’ contractors
You use a specialist broker to bypass the templates created for PAYE salaried workers. It’s worth pointing out that contractor mortgage brokers don’t work like in-branch staff. Instead, they deal with underwriters at head office.
Having this direct line to senior underwriters gives us insight into how they think. Heck, we’ve even developed the process with lenders unsure of how it all worked.
So we know how they think. We know how underwriters compare the respective commitments of each type of worker.
In their favour, a Limited Company contractor has, more often than not, invested in:
- an accountant to optimise for the genuine tax breaks on offer;
- creating a limited company, separating themselves from debt;
- a tangible business, with its own brand and perceived value.
Compare that to an Umbrella worker.
True, Umbrella contractors know that whatever money they pick up is theirs. And they have little involvement with paperwork, minimising the opportunity for error.
But this route doesn’t maximise their earning potential. Nor does it imbue a sense of ownership.
The responsibility of creating a long-term sustainable business speaks volumes about the contractor’s intent. And let’s not underestimate that in the eyes of someone about to approve a huge loan.
What do we advise?
In our experience, presenting an Umbrella worker’s payslips only confuses lenders. They’re not the same as those which a director/employer using RTI would produce.
Even ‘contractor-friendly’ banks and building societies struggle with the intricacies of such payslips. Let’s face facts, a moment. Who volunteers to pay more National Insurance if they can claim so little of it back?
These lenders, they have a point.
So, how about if you’re only dipping your toe in contracting waters?
The lender will consider whether it’s the right time for you to be taking on a mortgage. How will you meet repayments if you decide it’s not for you, after all?
This is how it works. The more longevity we can prove, the greater your chances of mortgage success. Not just of approval, but for your own long term ability to meet the repayments.
If you’ve appointed a contractor accountant, they’ll keep paperwork to a minimum. This will eliminate any concerns we may have over evidence of earnings.
Accountants also know how to display a limited contractor’s true earning potential. This then helps the specialist broker package an application in the most efficient manner. As a result, the underwriter can clarify relevant earnings for affordability purposes with confidence.
Lenders may also perceive lower risk if your business is a separate liability.
And that’s what it’s all about. You must prove that your contractor business supports your mortgage application. If it’s raining, a solid roof over your head beats relying on an umbrella every time!
Author: John Yerou
John Yerou is the owner and founder of Freelancer Financials; a trading style & trade mark of the award winning Mortgage Quest Ltd. One of the most recognised names in providing mortgages for contractors and freelancers across the UK.
In 2004 John began his career in Financial Services as an independent mortgage adviser and broker. John has been instrumental in negotiating bespoke underwriting for contractors with high street lenders.
His presence in the industry as a go-to expert is growing by the day and he is regularly cited and writes in publications both locally and nationally.