What is an Umbrella Company and How Does it Work?

If you’re a self-employed contractor, there are many benefits to registering as a limited company. Registering as a limited company is a relatively straightforward process. But it does bring a range of extra costs and responsibilities. Head here to read our full guide to changing from a sole trader to a limited company.

Running a limited company can be an immense challenge. It’s not always the best choice for contractors. But is there an alternative?

Yes – when you can no longer get by as a sole-trader, and when you don’t quite feel ready to register as a limited company, you could always join an umbrella company.

Self-employed contractors can join an umbrella company if they don’t want to run their own limited company

What is an Umbrella Company?

An umbrella company is an organisation that self-employed contractors can join. It’s an alternative to registering as a limited company. When you join the umbrella company, you technically become one of their employees. They’ll take care of all that nitty-gritty paperwork, such as your accounts and your taxes.

They’ll leave you free to get on with your contractor work, so you’ll no longer invoice your own customers. The umbrella company will do that for you. So your customers will no longer pay you directly. They’ll instead pay the umbrella company. Then the umbrella company will pay you.

This might sound like an unnecessarily complicated arrangement. But this is where the appeal lies: The umbrella company will handle taxes on a pay-as-you-earn (PAYE) basis. So they’ll deduct all necessary taxes, National Insurance contributions, and pension payments on your behalf.

The Benefits of Using a Limited Company

Many contractors don’t like the hassle that comes with running a business. They just want to get on with their contracting, while leaving all the paperwork to someone who knows what they’re doing. That’s why umbrella companies are the ideal choice for many contractors.

Short term contracting
Some contractors join umbrella companies on a short-term basis. Perhaps you know you won’t be contracting for long, so it doesn’t make any sense to go through the considerable hassle of registering as a limited company.

Not feeling ready
Some contractors simply don’t feel ready just yet to register as a limited company. Your business might be growing, but perhaps you don’t feel ready for all those extra costs and responsibilities.

Benefit from employee rights
Plus, as you’re an employee of the umbrella company, you’ll get access to various employee rights that you wouldn’t have received as an independent contractor. These include sick pay, holiday pay, and a workplace pension.

Are Umbrella Companies Legal?

It’s perfectly legal to join an umbrella company! However, some umbrella companies are essentially tax avoidance schemes. They’ll do all they can to ensure their contractors make more money and pay less tax. This, of course, is illegal.

So if you want to join an umbrella company, do your research. Avoid any umbrella companies that promise to boost your profits. And only ever join an umbrella company that’s registered with the FCSA.

IR35 Status and Umbrella Companies

IR35 is tax legislation designed to prevent contractors from providing services on a freelance basis to avoid paying required taxes. IR35 is complicated. And in 2020, the rules changed, which perhaps made things even more complicated.

We have several guides to IR35:

If you’re a contractor, your employment contractors can either be “inside IR35”, meaning the rules apply, or “outside IR35”, meaning they don’t.

Does Using an Umbrella Company Avoid IR35?

Operating through an umbrella company is not a way to avoid the IR35 tax. This is because, if you use an umbrella company, all of your contracts will technically be inside IR35. And this is the major downside of using umbrella companies: You’ll miss out on all the tax benefits that come from operating as a limited company, and you’ll always be inside IR35.

The only way to avoid IR35 tax is through only taking on contracts that fall outside IR35. And for that, you’ll probably need to register as a limited company.

Extra Safeguards Against IR35

So long as you truly are a contractor or a freelancer, and so long as you take care in the wording and the terms of your client contracts, you should never have to worry about IR35. But with that being said, an IR35 investigation may strike without warning. Would you be able to cope with the expenses and the interruption that would come as a result of your investigation?

This is why it’s worth investing in legal expenses cover as part of a professional indemnity insurance policy. This will cover you for any legal costs that might arise from an IR35 investigation. If HMRC ever open an enquiry into your accounts, your insurance will take care of all your legal fees from day one.