An easy-to-understand guide to Limited Companies for contractors
Anyone who is considering becoming a contractor should know that accountancy experts all consider that setting up, and working through, your own limited company is by far the most tax efficient way to run your business. You may think that the tax situation is too complicated for you to navigate, but this guide will give you answers to some of the questions you might have about how the financial side of things works.
Of course, the tax system can be complex, but setting up a limited company and dealing with the relevant admin need not be an onerous task or one which takes up a huge amount of your time. When you consider the potential benefits of doing so, it is definitely worth learning more about how you could save money and prepare for a financially stable future.
If you are new to contracting then you may find the following pages useful:
Limited Company Tax (rates correct as of April 2014)
For the purposes of understanding your tax position as a limited company, it may make it easier to think of the company as a separate entity, with your role as owner and employee of the company being completely separate.
Limited companies are subject to Corporation Tax, which is currently 20% on all profits for companies which earn less than £300,000. This means, for example, that if you invoice a client for £100,000 (excluding VAT) and your business costs total £20,000, then you will be taxed 20% of the remaining £80,000.
This tax payment will be due 9 months and 1 day after year end, which is known in business as the financial year.
Employer's National Insurance Contributions
Whatever salary your company pays you will attract a tax of 13.8% on any amount over the threshold of £153 per week.
If you work through an umbrella company, then you will need to pay 12% employees National Insurance on your salary as well as 13.8 employer’s National Insurance as your own employer. This means your salary will cost you a total of 25.8% on your total amount of pay, once expenses and threshold allowances have been deducted.
VAT (Value Added Tax)
Most contractors are registered for VAT, which is chargeable at a rate of 20%. This sum is added to your invoices and paid to HM Revenue and Customs, so you are effectively collecting this tax on behalf of the government.
However, many of those contractors who charge VAT also register for the Flat Rate VAT Scheme which allows those collecting VAT to pay it to the government at a lower rate than they charge their clients. IT contractors, for example, usually repay VAT at a rate of 14.5% (and there is even a discount for the first year, meaning newly registered businesses can repay at 13.5%).
This means that you can keep the difference, and although this is then taxed as profit, it can still amount to a significant sum every year which is available to you as the owner of a limited company.
Contractor Tax – personal taxes (tax rates based on April 2014)
Income Tax including PAYE
When you start to take home an income in the form of a salary as well as dividends from your company, the administration can get a little more complicated. You will need to start thinking of your income as being earned over the fiscal year, from 6th April one year to the 5th April the next.
You will be entitled to a tax free allowance of £10,000, and any salary you earn in excess of this will be taxed at a rate of 20% until the threshold of £41,865 after which you will be taxed at 40% on the excess. If you earn more than £150,000 then you will be taxed at a rate of 45% on any amounts over this.
If you earn more than £100,000, then your personal allowance will be reduced by £1 for every £2 over the threshold, so, if you earn £120,000, then you will have no tax-free allowance. This means that for the first £20,000 earned over £100,000 you will effectively be taxed at 60%.
Until you cross the threshold of £41,865, any dividends paid will not be subject to PAYE income tax or National Insurance. Once this threshold has been crossed, it will attract a 25% dividend tax rate applied to the net dividend drawn.
Employee's National Insurance Contribution
There is no National Insurance rate for dividends, as opposed to salaried earnings which are subject to a rate of 12% on earnings above £153 per week, although if you earn more than £805 per week, then you will only pay 2%.
PAYE income tax and National Insurance is payable quarterly, along with VAT, and your accountant will remind you of the dates well in advance to ensure that you are adequately prepared.
There number and varied nature of the applicable rates above may seem complicated, particularly as the threshold and allowances are subject to annual change which can be confusing. However, this is a simple breakdown of what is payable and when:
Corporation Tax – due 9 months and a day after year end
VAT – due quarterly
PAYE and National Insurance – payable quarterly
Your self-assessment tax return is due annually, with the deadline for submitting your paperwork and paying your bill being the 31st of January. It is likely that you will also need to make a payment on account in July as a down-payment on the next year’s tax bill.
Whilst negotiating the world of personal and business tax can seem complex, once you have your finances organised it can be as simple as entering the relevant data into a spreadsheet and submitting it to your accountant. You should not let the tax system put you off pursuing your dreams of owning your own business, particularly as a specialist accountant can take all the stress out of it by offering advice, reminders and expertise throughout the year.