Contractors work on fixed-term contracts. They could be PAYE employees, sole traders, or employees of an umbrella company. PAYE and umbrella company contractors are employed and paid a salary by their employers, while sole traders are self-employed and send invoices to their clients.

The structure of your contracting career will depend on a number of factors, including:

• Whether you provide services to other companies or if this is your only contract.
• Your industry, specialism and skill level.
• How you found the role, e.g. via a recruitment agency
• Your client’s preferences. 

Unlike PAYE and umbrella companies, sole traders should avoid providing services to just one client, as this might cause tax implications if HMRC believes your ‘employment status’ to be incorrect. We’ll talk more about this, and IR35 for limited companies, later on in this guide. 

Reading this as a contractor and need help making sense of your accounts? Chat to our team about our contractor accounting service, and start saving time and money today.

Let’s dive into contractor setups and making the most out of your contracting career.

The fundamentals of contracting

A contractor provides a service to a company for a set period of time. They could either be employed by the business on a fixed-term contract, contracted via an umbrella company or self-employed. All three options are common, but knowing which is right for you depends on a few different factors…so let’s take a look. 

What is an umbrella company?

An umbrella company is typically owned by a recruitment company. This company employs contractors on fixed-term contracts on behalf of other companies. Essentially, this means that the umbrella company employs you but provides your services to another business. That business then pays the umbrella company plus an additional fee to cover Employer’s NI and other services.

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What about if you are contracted directly by the end client?

In this case, you are a PAYE employee of the company and are typically working on a fixed-term contract.

There is no direct comparison between an umbrella company vs PAYE– either way, you are a PAYE employee; what’s different is which company pays you and manages your payroll, taxes and deductions.

Here’s a side-by-side comparison of contracting under PAYE vs an umbrella company:

PAYE contractor

• Employed directly by the company
• The terms of your employment are negotiated and contracted by the employer, who will then pay you minus taxes, National Insurance and other deductions.

Umbrella company contractor 

• Employed by the umbrella company, but reporting to the company for your work responsibilities.
• You submit timesheets to the umbrella company, and they invoice the client for your work plus their fee.
• You are paid by the umbrella company minus taxes, National Insurance and other deductions.
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Can I set up my own umbrella company?

Perhaps you are reading this wondering if you can set up your own umbrella company, or use an existing company as an umbrella to invoice a client for your contracted work. This is not advisable as you will only be contracted for work by one single company, whereas an established umbrella company, like the one run by a recruitment agency, will employ multiple people and contract to various different companies.

But why does this matter? To understand why you can’t just run your own company but only contract to one client, you need to get acquainted with IR35. 

What is IR35?

IR35 is a tax legislation brought in place to restrict contractors from using an intermediary, such as a limited company, when they would otherwise be considered employees without the intermediary. 

Essentially, if you run a limited company, but are only contracted to one client, this would mean you are operating inside IR35, which means:

• The contractor is considered an employee for tax purposes.
• The intermediary (your limited company) must deduct income tax and National Insurance Contributions (NICs) as if you were an employee.

IR35 aims to prevent tax avoidance and ensure contractors are set up in the correct way to pay tax. By having only one client, a limited company risks breaching IR35 as, without that company, you would be seen as an employee of the client.

When inside IR35:

• The client must treat payments to your limited company as employment income.
• Income tax and NICs are deducted from the source.
• This removes the main tax benefits of operating through a limited company, such as paying yourself through dividends, which are taxed more favourably than salary.

Why can I not have only one client inside IR35?

Having a single client significantly increases the risk of being classified as inside IR35 because:

• Control: If the client dictates how, when, and where you work, this indicates employment rather than self-employment.
• Mutuality of Obligation (MOO): If the client expects you to accept work and you expect the client to provide ongoing work, it resembles an employer-employee relationship.
• Financial Risk: True self-employment involves financial risks (e.g., not being paid if work is not delivered), but working exclusively for one client can appear to lack these risks.
• Substitution: If you cannot send a substitute to perform the work, this further suggests an employment relationship.

The risks of having one client:

• Unexpected compliance costs with IR35 regulations.
• Reduced retained profits in the company due to higher tax deductions.
• Potential liability for unpaid taxes if HMRC challenges your status and deems you non-compliant.

Still not sure where you sit with IR35? Read our full guide to IR35 here. 

Is it possible to be a contractor outside of IR35?

To ensure compliance, the only way to contract outside of IR35, via your limited company, is if you have multiple clients and, therefore, would not be otherwise seen as simply an employee of that company.

For example, you might be contracted for three days a week at a company, but you can also provide work for other clients throughout the week. This could be considered outside of IR35, especially if you don’t receive the same benefits as other company employees.

It’s all about how your contracting situation is set up, and whether you are working as a freelancer with multiple clients, or simply a fixed-term employee of one company.

Like the idea of working with multiple clients at once? Learn more about freelancing and how to become a freelancer in our guide.
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Contracting as a sole trader

Some contractors might be sole traders, but you need to ensure that you are set up in the right way to avoid tax implications. If you provide services to multiple clients, you can be self-employed and send invoices to the end client for your work. 

However, if the company is your only client, you risk being flagged as having the incorrect ‘employment status’ – i.e. HMRC believes you to be essentially employed by the company, but set up as a sole trader to avoid tax. If this happens, HMRC might hit you with National Insurance and other tax bills if it deems you as having the wrong employment status.

So, while sole traders are not subject to IR35, it doesn’t mean you are free from consequences if you choose this approach to contracting. 

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Additional considerations

The fact is, as a contractor, you might not even have a choice between becoming a PAYE employee of the client vs working for an umbrella company. That’s because the company itself typically decides this setup based on what’s most financially viable for them. 

For example, it’s likely cheaper for them to employ you directly, but there are more administrative and HR obligations with this approach, so many larger businesses will choose to outsource contractor management to a recruitment agency with an umbrella company for a fee. 

If you are faced with the choice or have been offered a contracting position with one of the two structures, here are things to take into account:

Want help deciding between starting your own company, becoming a contractor and working for an umbrella company? Take a look at our detailed comparison guide. 
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Umbrella vs PAYE: FAQS

1. Do you pay less tax with an umbrella company?

No, you don’t generally pay less tax with an umbrella company.

As a contractor, you are still a PAYE employee; you are just contracted with the umbrella company rather than the company directly. Therefore, your tax liabilities aren’t impacted, rather the setup and administrative layout of your role is different. For example, you may have to submit timesheets or have overtime restrictions– it all depends on your contract, either with the company or the umbrella.

2. What are the disadvantages of an umbrella company?

Working for an umbrella company might result in lower tax home pay as they take administrative deductions to cover their costs, but this isn’t always the case. Other disadvantages for contractors may include a lack of employee benefits, like social events.

3. Can I claim expenses as a contractor?

It depends on your contract, but as a PAYE contractor or umbrella company contractor, you are still an employee, so your expenses depend on the employer’s rules.

What does outside IR35 mean?

4. Does IR35 apply to sole traders?

Although IR35 does not apply to sole traders, it’s still not wise to have only one client as you are bound by ‘employment status’ restrictions. If HMRC determined you were using sole tradership to disguise employee status, then you might be subjected to additional National Insurance and other tax liabilities. 

Kickstarting your contracting career

So, now you have a better idea about how contracting works, and what setup is right for you.

If you’re thinking of becoming self-employed or starting a limited company to work with multiple clients at once, get in touch with Crunch’s team of experts to make sure your accounts are all in order. With our cloud-based software, you can take the stress out of bookkeeping, alongside access to qualified accountants with experience working with businesses like yours.

And if you’re an employed contractor, but also have self-employed income, or are in any other complex financial situation, speak to our team to help clarify your taxes and make accounting easy. 

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