Freelancer Financials

Umbrella Companies – A Guide for Contractors

Umbrella Companies – A Guide for Contractors

on in Contracting Matters Blog.
Last Updated on July 8th, 2017 17:08pm.

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Pink and white umbrella by beachSo. You’ve secured your first contract. You’re with your recruitment agent, who says “Great. Now you need to find an umbrella company“.

Or you may not be quite at that stage. Instead, you’re mulling over leaving your permanent role to take up a contract offer. You’re not quite sure what that will entail. Now you’re researching ways to operate, umbrella companies being one such way.

To help you make the right decision, you need to know why umbrella companies were born. Moreover, what their role is today amongst the options open to you. Let’s go.

Why do Umbrella Companies exist?

Umbrella Companies rose to prominence when IR35 tax legislation became statute 1999. The Government launched the legislation to catch what they deemed ‘disguised employees’.

What’s the definition of a disguised employee?

Imagine that you worked in a permanent role for a direct employer, as most people do. You and your boss agreed you’d be better off in the same job, but as a self-employed entity.

The boss would then make you redundant on Friday. But you’d then reprise your role on Monday but with a self-employed contract. IR35 was born to distinguish contractors from employees who’d traversed this route.

And, yes. It worked. Many contractors fell foul of the guidelines and deemed “inside IR35”. Bye-bye savings on NICs and income tax. Hello years of scrutiny and higher taxes.

What is an Umbrella Company?

In its simplest form, A PAYE umbrella company is a standard UK limited company. The difference is that it’s operated by a third party supplier. They adopt a role similar to an ’employer’ on behalf of its contractor employees.

The Umbrella Company signs a contract with the recruitment agency or end client. The contractor who’ll be carrying out the assignment, in effect, works for the Umbrella.

The umbrella provides many services to its employees. A PAYE Umbrella treats all your income as salary. This means you pay employers NI, employees NI and PAYE on all your income.

In effect, they’re taking away the headache of running the contractor’s business. They:

  • process all timesheets;
  • raise invoices on behalf of the contractor;
  • take into account the necessary tax deductions;
  • then pay its employees a salary after tax.

The result means the contractor working for them needn’t worry about the IR35 legislation.

How does an umbrella company work in practice?

Here are the steps you’ll take if you join a UK-based PAYE umbrella firm. They assume you’ve already won a contract and your hours are set:

  1. the umbrella company (as your ’employer’) signs a contract with your recruitment agency;
  2. you’ll also sign a contract of employment with the umbrella;
  3. you fill in a timesheet for the time spent carrying out the contract on site. You then pass it on to your manager to sign;
  4. submit your signed, completed timesheet, to both your recruitment agency and umbrella;
  5. the umbrella company will invoice the recruitment agency, who then bill the end-client;
  6. once the umbrella company receives payment from the agency, they can prepare your payroll;
  7. your umbrella will process your payroll and pay you a salary after deductions;
    • this will include income tax, NICs, the pre-agreed umbrella fee, and any other deductions;
    • they will also reimburse you for any allowable expenses you have claimed;
  8. As your employer, the umbrella will apply a relevant tax code upon receipt of your P45 or P46;
    • this P45/P46 enables the umbrella company to maximise your personal allowance;
    • contractors will then receive a payslip to support their payroll;
  9. As an employer, umbrellas will also produce a P60 at the end of the financial year.
  10. And, once your contract/employment has ended, a P45.

What are the main reasons for choosing the Umbrella route?

There are certain circumstances that scream: great fit for an umbrella company. These hinge on your attitude to the contractor lifestyle and your gross contract value.

You need to decide whether your culmination of elements raises the decibel level. Umbrella companies:

  • are a hassle free way of working for contractors earning below 25k per annum;
  • allow contractors to increase take home pay (compared to working PAYE direct through an agency or client).
  • allow you to trial run a contracting career before making a long term commitment;
  • are ideal if you plan to work as a contractor for only a limited period;
  • offer a bona fide way to work if you expect that most or all your contracts will be caught by IR35*.

* Do you suspect you might be inside IR35? If so, there’s little or no financial justification going the limited company route.

You’d still have to pay full PAYE and NI contributions if caught. An umbrella company in this case would be a viable option.

One quick word of note. Be careful if you’re induced by an agency to join one umbrella company or another. This is illegal under the 2010 Bribery Act but it happens.

Beware of Dodgy Offshore Umbrella Schemes

For many years, offshore tax schemes have lured contractors ‘to the dark side’. They promise a higher level of remuneration, but beware the true cost.

Offshore umbrellas market schemes to contractors stating that they’ll receive 85% – 90% retention. In other words, they keep much more of their contract income than by other routes.

But offshore tax avoidance schemes are complex payment structures. These schemes filter a contractor’s pay through an offshore Third Party trust.

The trust then returns the money to the original contractor as a non-taxable loan. This allegedly does not have to be repaid! Make sense? No, we don’t think so either.

HMRC have recently adopted a more aggressive stance on these types of payment structures. They’re taking a “guilty until proven innocent” approach with their Accelerated Payment Notices.

The upshot is that members of offshore schemes may have to pay any tax due. But not at a preferred rate; they’ll have to pay tax as if they were employees.

This may mean some liability at the 45% level, plus 2% National Insurance. HMRC are still deciding whether they can get the scheme approved. If they do, the scheme could mean tens of thousands of pounds in up-front payments!

Can I still apply for a mortgage if I’m using an Umbrella Company?

Contractors often ask us which is easier. Getting a mortgage as an Umbrella employee or through their own limited company.

There’s this misconception that contractors using an Umbrella company have an easier time. It’s actually the other way around. Contractors using their own Limited Company have more options than working through an Umbrella.

If you’re using your own Ltd company, you get two bites of the cherry when it comes to applying for a mortgage. To work out your affordability, different lenders will either:

  • work off your salary and dividend;
  • or salary and net profit.

There’s another more contractor friendly route. This entails applying for a contractor mortgage based on your daily rate.

If you use an umbrella company, the lender is likely to ask more questions, not less. Who employs you? Why do your payslips not look like an employee’s payslips?

And believe me, it doesn’t stop there! The reason is that banks fail to grasp that you’re a professional contractor. Albeit one utilising a payroll service as a payment vehicle.

Umbrella Contractors typically get paid the statutory minimum wage for the hours they work. What tops up their salary is that they then earn a bonus based on the funds they generate.

Some mortgage companies do prefer basic wages when working out mortgage affordability. Commission or bonus related wages just don’t provide the security they’re looking for.

So how can you overcome these issues?

The key is to first find a mortgage specialist who:

  1. understands your fundamental workings;
  2. knows how to package your application based on your contract rate;
  3. has the knowledge of the marketplace to match all that to the right lender.

Without that applied acumen, lenders struggle to classify umbrella company earnings for affordability purposes.

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.


Semantic Tags: Contract, Employment agency, IR35, Pay-as-you-earn tax