Umbrella Company Facts You Need to Know

There are many misunderstandings among contractors and freelancers relating to working with an umbrella company. An umbrella company is, in short, a legal business entity that hires contractors and freelancers under a contract of employment. All transactions between umbrella companies and their contractors are subject to HMRC and Inland Revenue regulations. Here is a list of 14 umbrella company facts you need to know, whether you are contractor or a recruiter:

An Umbrella Company Cannot Minimise Tax Contributions

Tax contributions are established by the tax code, not umbrella companies or clients. Furthermore, all payments made to contractors from an umbrella company must go through the government's Pay As You Earn (PAYE) scheme except under certain limited IR35 exceptions. The contractor's pay on any job can include salary and qualifying expenses; the umbrella company deducts taxes, national insurance contributions, and their fees from invoice payments.

Some Umbrella Companies Allow More Expenses than Others

Umbrella company accountants process expenses according to what the law allows. All expenses must be recorded on Inland Revenue form P11D, with receipts available to prove such expenses. Although the government does allow special exemptions relating to documentation of expenses, those exemptions do not apply to umbrella company contractors or freelancers. Each contractor must support all expense claims with the appropriate receipts.

All claimed expenses must qualify under the law, and they must have been incurred wholly and exclusively while providing work under an employment contract. Furthermore, the exemptions granted to umbrella companies for expense reporting does not allow contractors and freelancers to claim the maximum allowable amount for a particular kind of expense when the actual expense is less than the maximum.

Contractors Cannot Claim Unlimited Subsistence Allowances

Contractors working under an umbrella company can claim a daily subsistence allowance of £5 (£10 if working outside the country) without supporting documentation. However, they must provide receipts for any other expenses claimed. Those receipts must be kept for a minimum of five years, according to the Inland Revenue. Furthermore, the Inland Revenue will not blindly accept large amounts of undocumented expenses under any umbrella contract. An umbrella company claiming to be able to increase take-home pay through larger subsistence allowances or other undocumented expenses could be breaking the law.

Claims for Meal Expenses Are Limited

The law allows umbrella companies to accept meal expense claims only for those days that contractors are working remotely. Working remotely is defined as working away from one's usual location or in a locale requiring an overnight stay away from home. Only actual meal costs supported by receipts can be claimed. Such expenses are deemed, under normal working conditions, to be a matter of basic survival and therefore not wholly the result of fulfilling a work contract. Therefore, they cannot be claimed as an expense outside of the remote work qualification.

Legitimate Expenses Do Reduce Taxation

An umbrella company may encourage contractors to take advantage of as many qualified expenses as the law allows, with the understanding that higher expenses reduce taxation. Remember, however, that receipts must support all qualifying expenses. Actually spending the money may reduce the amount of taxes you pay, but doing so just for the sake of reducing taxation is not necessarily a wise financial decision.

Margin Should Be the Only Difference between Individual Umbrella Companies

An umbrella company advertising higher take-home pay through lower taxation is being deceitful. HMRC and Inland Revenue regulations determine income tax, National Insurance contributions and legal, qualifying expenses. These are all things the umbrella company has no control over. The only difference between umbrella companies is their individual margins. The company legally providing the highest take-home pay is the one with the lowest margin.

Exceeding 24 Months at a Single Location Changes Expense Calculations

Freelancers working under an umbrella contract can work at a single location for up to 24 months and still qualify for all legally allowed expenses under the law. Once 24 months has been exceeded, the work location may be deemed a more permanent one, eliminating some expense claims if the contractor spends more than 40% of his/her work time at that location. The 24-month rule, as it's known, applies to work sites rather than umbrella companies. Therefore, switching to a different umbrella company to avoid the rule will not work.

Contractors Can Earn More via Minimum Salary and Dividends Payments

It is possible to increase one's take-home pay through a combined minimum salary and dividends scheme. However, this is only possible if the contractor has set-up his/her own Limited Company and his/her umbrella contract falls outside of the scope of IR35. Certain stipulations apply to Managed Service Companies, legal business entities existing as limited companies with third-party involvement outside of accounting. Such companies are still governed by IR35, and they must pay contractors through PAYE.

Umbrella Companies Are Not Managed Service Companies

Umbrella companies exist to provide employment to contractors and freelancers through umbrella contracts. Because contractors and freelancers are treated as employees under the law, and payment is made in the form of salary plus qualified expenses, umbrella companies do not qualify as Managed Services Companies. The practical application of the law means that umbrella company contractors will not be liable for additional taxes above and beyond that which the umbrella company deducts from client payments. From a contractor's perspective, it is no different from working for another company as a salaried employee.

A Portion of Salary Can Be Paid to Partners under Some Circumstances

The contractor working through an umbrella company can pay a portion of salary to a partner to reduce individual taxation. However, certain conditions apply. First, there must be a legitimate commercial arrangement between the contractor and partner. Second, the contractor must set up a limited company through which payments are made.

IR35-Friendly Contracts Are Risky

It is technically possible to structure on umbrella contract that is IR35 friendly (i.e., a contract that falls outside the scope of IR35), but such contracts are precarious. For example, a contract claiming that you can provide certain kinds of services you are incapable of providing could land you in legal trouble. You might also be held liable for back taxes and penalties if a minimum salary and dividend payment plan under a limited company is deemed to fall within IR35. Lastly, an IR35 friendly contract does not protect you against Inland Revenue investigation.

Working with an Umbrella Company Is Not Protection against Inland Revenue Investigations

Any umbrella company offering contractors blanket protection from Inland Revenue investigations is being dishonest. Inland Revenue randomly investigates both umbrella companies and contractors to make sure everything is legal. Should an umbrella company and contractor attempt to claim expenses not allowed under the law, it could trigger an investigation resulting in back tax payments and penalties.

UK Offshore Umbrella Companies Are Illegal in the UK

An offshore umbrella company attempting to recruit contractors by claiming reduced taxation and National Insurance contributions is breaking the law. From 1987, it has been illegal in the UK to work with offshore umbrella companies for the purposes of tax avoidance. Should a contractor be caught doing so, he/she would likely face a significant tax bill as well as penalties and interest payments.

Online Wage Calculators Can Only Provide a Rough Estimate

Certain umbrella companies offer online wage calculation tools to help contractors figure out how much they can earn by signing up. Contractors should remember that net earnings are affected by taxes, National Insurance contributions and qualifying expenses. Because expenses are not considered by a wage calculation tool, the returned number is only a rough estimate. Contractors should not rely on it as the sole determiner when deciding whether to sign up with an umbrella company or not.

Working under an umbrella company is a legitimate payroll and tax solution that enables contractors and freelancers to continue doing what they do without setting up their own companies. For their protection, contractors and freelancers need to fully understand how umbrella companies work in terms of invoicing, reporting, taxation, expenses, and deductions. Being fully informed enables contractors to make sound decisions.