If you’re an IT professional thinking about contracting, our easy-to-understand IT contractor tax guide will help you make sense of how taxes work for contractors.
The types of taxes you will pay working independently will vary depending on if you are going to start a limited company for contracting purposes, or work through an umbrella company.
Limited Company Tax & Deductions
If you contract via your own limited company, it is a separate legal entity from you – the director and shareholder – therefore it has its own tax to pay. Here are the types of liabilities your company will need to pay:
All companies must pay Corporation Tax on their annual profits. When you set up your limited company, whether on your own or through an accountant, your company will be registered for Corporation Tax. Unless you inform HMRC that the company is dormant, you will pay the tax due when you file your company’s Corporation Tax Return. The Corporation Tax rate for the tax year 2017/18 is 19%.
Employers National Insurance Contributions (NICs)
Because you effectively are employing yourself, your company pays a salary to you and pays tax on this salary on your behalf. Therefore, on top of your normal income tax and NICs, your company must also pay employers NICs on the salary amount via Pay As You Earn (PAYE). The company will pay Class 1 NICs at a rate of 13.8% on any salary paid over the amount of £157 per week, or £680 per month. No employers NI needs to be paid on salaries under this minimum.
Value Added Tax (VAT)
VAT is a tax that is payable on the majority of goods and services in the UK, including services provided by limited companies. If your limited company’s turnover (gross income) for 12 months is or is expected to be £85,000 or greater (post-April 2017), you are legally required to register your limited company for VAT. In some cases, it may be beneficial for you to register your company for VAT, even if your company’s turnover is less. We recommend you consult a contractor accountant about this.
When registered for VAT, your company invoices its clients at the standard rate, which is 20%. Your company will repay the VAT received to HMRC; the percentage you pay depends on whether your company is registered to the Standard VAT scheme, the Cash Accounting scheme, or the Flat Rate Scheme.
There are also taxes that you as a limited company Director and shareholder pay. These are:
As a contractor who is also a shareholder of the limited company, you can take a portion of the company profits as dividends, which unlike salary, do not attract NICs. This is one reason why limited company contracting can be more tax efficient and yield in a higher take home pay than umbrella companies (if the tax status is outside IR35).
Dividends are tax-free up until an annual allowance of £5,000, after which they’ll be taxed at 7.5% until they reach £32,001, where they are taxed at 32.5%. Find out more about IT contractor dividend tax and how it works.
As a shareholder, dividend taxes are payable at the time of your annual self-assessment, which you use to declare income that is not taxed at the time you received it.
Employees National Insurance Contributions (NICs)
When you take a salary as a Director, you pay employees NI on the salary via PAYE. If you choose to pay yourself a lower salary and take more in dividends, your income will attract less employees NI. Weekly salaries between £157 and £866 per week pay NI at 12%, and weekly amounts over £866 per week are subject to 2% deductions.
Any salary you take through your limited company above the tax-free allowance of £11,500 will be subject to income tax. Income tax is 20% for income over £11,500 and up to £45,000, 40% for income over £45,000 and up to £150,000, and 45% for income over £150,000.
If you decide to take a lower salary and take more income through dividends, you will attract less income tax. Income tax is payable at the time of your self-assessment filing.
If you contract through your own limited company as a contractor, you must declare your untaxed income on a yearly self-assessment, which is due every year by 31st January if you file the return online.
Read more about self-assessments
IR35 is a piece of tax legislation used to collect tax from limited company contractors who are not paying the correct amount of tax. If the assignment you take on is caught by this legislation, you will have to pay yourself completely through salary rather than a combination of salary and dividends. This results in paying the same amount of tax and NICs as a regular employee.
Find out more about IR35 legislation and what you can do.
IT Contractor Tax for Umbrella Companies
If you contract through an umbrella company, you will be taxed as if you were a regular employee. This means that your whole income is subject to income tax via PAYE as well as NICs, which will be deducted before you receive your pay. This also means that you won’t have to worry about IR35 legislation as you will already be taxed as a regular employee.
Umbrella companies will calculate and deduct your tax on your behalf, which is one reason why it makes this an easy and hassle-free payroll option. However, there is little to no opportunity to reduce your tax burden through an umbrella company; only a minority of contractors can legally claim tax relief on expenses, such as travel and subsistence, through an umbrella company.
If you work via an umbrella company, you will not have to file a self-assessment unless you have other income that is not taxed up-front, such as property income.