Getting started as an IT contractor

Starting out as a contractor can be a daunting experience, particularly if you are moving straight from regular employment. The extra work required can seem extreme; you must market yourself, find and negotiate contracts, look after your tax and annual returns – and, of course, do the work you are contracted to do.

However, once you are into the swing of your new life as a contractor, you are likely to find that it is not as difficult as you first imagined. Getting yourself organised from the outset can help ensure that, further down the line, you are free to work and find contracts rather than flailing around in a tangle of paperwork.

Legal structures for contractors

Deciding on a suitable legal structure should be one of your first tasks when starting out as a contractor. This decision will, to an extent, depend on whether or not your contracts are likely to fall within the IR35 rules. IR35 is the bane of many a contractor’s life, and it is vital that you understand its implications for you.

What is IR35?

IR35 was announced in 1999, and came into force in April 2000. It is legislation that effectively allows HM Revenue and Customs to treat some contractors as employees, and tax them accordingly, when they judge that they are employees in all but name.

The original purpose of IR35 was to prevent highly paid employees becoming self-employed ‘contractors’ in order to mitigate a tax and National Insurance burden but, to all intents and purposes, carrying on in employment exactly as they had been. However, IR35 has had significant and detrimental effects for other, perfectly legitimate contractors.

IR35 allows HMRC to ‘construct’ a contract of employment where they judge a contractor is, in fact, an employee. If your contract is deemed to fall ‘within’ IR35, you could see your post-tax earnings reduced by up to 25 per cent. More information on working out when you are affected by IR35, and how to avoid it, can be found later in this guide.

The legal structure under which you operate will have an effect on your IR35 position. While it will not affect the nature of the contracts you take on, it could affect your take-home pay. Your choice of legal structure should be thought of as a choice between payment processes, rather than a decision that will have any effect on your contracts themselves.

Broadly speaking, you have two main options: you can form your own limited company, or you can use an ‘umbrella company’.

Forming a limited company

For most long-term contractors, forming a limited company is the most cost effective option. While it involves a fairly significant initial time investment, the potential benefits down the line should be fully considered.

As Director of a limited company, you will have complete control over the day to day affairs of your business. This has a number of advantages; primary amongst these is the fact that there is no middle-man through which you must be paid. This can save valuable time and help to ease your cashflow.

A limited company is also valuable if you wish to give the impression that you are not just a one-man-band. For example, when applying for large contracts it may be in your interest to give the sense that yours is an established or sizeable organisation. A limited company with a ‘respectable’ registered address (which is included in many company formation packages) can help give a good first impression.

Using an umbrella company

The second option is to use the services provided by existing ‘umbrella companies’. These are simple to find, and beginning a relationship with one requires little of the work associated with establishing and running a limited company.

On a basic level, umbrella companies are a means by which you can outsource your payroll requirements. Rather than being paid directly by your clients, your payment would be processed by the umbrella company. You would submit a timesheet to the umbrella company, who would bill the client. The umbrella company would deal with all accountancy and tax issues, and all of your income would be treated as if it were a conventional salary.

There is significantly less work involved for those who choose to go down the umbrella company route. However, there are a number of significant drawbacks.
Primarily, the tax burden for contractors who use umbrella companies is far higher than for those who become company directors. All salary drawn through an umbrella company is subject to employer’s and employee’s National Insurance, as well as NI Contributions.

Limited companies, umbrella companies and IR35

While your choice of legal structure will not have any effect on the legal status of your contracts, it will have a significant effect on your tax liabilities. If you choose to use an umbrella company, your contracts will be treated for tax purposes as if they are all inside IR35 – even if, in a legal sense, they fall outside the legislation.

As a result, long-term contractors will almost always be better off forming their own company, rather than using an umbrella.

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