Contractor Tax Planning – A Complete Guide

Contractor Tax: Introduction

Contractors and freelancers make up a larger proportion of UK professionals than ever before. According to the Office of National Statistics, there are now over two million contractors working in the country – contributing £119 billion to the economy.

With technology advances making it easier for people to work for themselves, the number of UK contractors increased by 43% between 2008 – 2016 and continues to grow exponentially.

As a contractor, you need to be aware of different tax implications – including IR35 legislation – to make sure that your business operates as efficiently as possible. Our Contractor Tax Planning Guide has been designed to help self-employed professionals:

  • Comply with UK business and tax law
  • Identify potential tax savings
  • Recognise opportunities for growth through tax planning
  • Protect themselves against uncertainty

While the guide provides an overview of tax planning for contractors, it’s not a replacement for professional, money-saving advice that can be tailored to your individual needs and circumstances.

Contractor Tax Rates

As a contractor, you can operate your business as a Sole Trader, a Limited Company, or under an Umbrella Company. There are fundamental differences between these business structures, including how each one is assessed for tax purposes.

  • Sole Traders (and Partners in Partnerships) are taxed as a single entity via the Self Assessment system each year – paying income tax and National Insurance Contributions (NICs) on their business profits after deductions for expenses.
  • A Limited Company is taxed as a separate legal entity from its owners and directors, and is subject to Corporation Tax on its annual profits. Directors must also complete an annual Self Assessment return to cover any income they have received as salary and dividends from the company.
  • An Umbrella Company acts as an intermediary between contractors and their end clients. The company often takes care of administrative responsibilities, including collecting your income and deducting tax and NICs (and an administration fee) before paying the remaining amount to you.

Self Assessment Tax Returns

Once you have registered as being self-employed, you should be sent a Self Assessment notice at the end of each tax year (between 5th April to 6th April each year).

All taxpayers are encouraged to submit their Self Assessment returns online these days. The deadline for paper tax returns is 31st October after the end of the tax year, whereas you have until the following 31st January to submit your tax return to HMRC online.

Income Tax Rates for Contractors

You will be taxed at different rates on any income above your Personal Allowance – this is the amount of tax-free income you are allowed each year, and currently stands at £12,500 for 2019/20.

The tax bands, thresholds and rates for income above your Personal Allowance are:

Basic rate tax band :£12,501 – £50,000

Basic rate income tax: 20%

Higher rate tax band :£50,001 – £150,000

Higher rate income tax: 40%

Additional rate tax band : £150,000+

Additional rate income tax: 45%

Payments on Account

When you have started paying tax through the annual Self Assessment tax system, you will also have to make payments in account. These are essentially advance payments on the tax that you’re perceived to owe for the current tax year.

Payments on account are paid to HMRC in two instalments each year – on 31st January and 31st July – and are the equivalent of half the amount of tax owed for the previous tax year.

For instance, if your Self Assessment tax bill for 2018/19 was £10,000, you would have to pay this AND an additional £5,000 payment on account (50% of the tax owed for the previous tax year) for the 2019/20 year by the same 31st January 2020 deadline.

National Insurance Contributions (NICs)

As a Sole Trader, you will also need to make National Insurance Contributions (NICs) depending on your level of earnings.

There are currently two types of NICs that Sole Traders have to pay:

  • Class 2 NICs (which are currently £2.95 per week)
  • Class 4 NICs (which are calculated by HMRC based on your profit; essentially 9% on your earnings between £8,424 – £46,350, and 2% on any profits above this).

Corporation Tax Rate

All companies pay the same rate of tax on their annual profits. The current Corporation Tax Rate is 19% – but is expected to be reduced to 17% from April 2020.

If you’re setting up as a Limited Company, your accountant will inform you of your new status and will complete and submit your Corporation Tax form (Form CT600) online. Your previous year’s tax must be paid within nine months of your company’s year end date.

Payments on Dividend Tax

Dividend Tax is imposed on the retained profits generated by companies of all sizes that are then distributed to shareholders. For contractors, dividends make up the majority of income drawn from small Limited Companies.

Dividend Tax is a personal liability that is paid annually as part of your Self Assessment Tax Return. After taking into account any other income, tax on dividends above a Personal Allowance of £2,000 is imposed at the following rates:

Basic rate<£50,0007.5%
Higher rate£50,000+32.5%
Additional rate£150,000+38.1%

Value Added Tax (VAT)

Most contractors register for VAT – even if they’re unlikely to exceed the £85,000 threshold across any given 12 month period. You can register for a standard or Flat Rate VAT Scheme, depending on your circumstances.

If you don’t claim large amounts on expenses, a Flat Rate VAT Scheme – where a set rate (14.5% for most contractors) is applied to your turnover – is attractive for contractors. And, in the first year of the scheme, you get an additional 1% discount on the flat rate (13.5%).

Contractor Tax Planning – The Basics

If you’ve decided to work as a contractor, it’s important to consider how effective tax planning can help you transform your finances, understand what tax deductions you qualify for, and ultimately create an ideal work-life balance.

Recording details of your income and expenditure is essential to accurate tax planning but, especially when you’re starting out, contractors should consider taking three recommended steps:

Set Up as a Limited Company

As mentioned, many contractors set up business as a Limited Company to legally maximise their disposable income. There may be additional responsibilities and administrative requirements involved – but a contractor can make larger tax savings as a Limited Company than being a Sole Trader.

A Limited Company allows for more tax saving opportunities as you can receive your income through a combination of salary and dividends. As a company director, especially if you are a single-person business, you have the flexibility to decide on the exact amount of tax you pay based on increasing or decreasing the dividends received.

There are also additional tax savings to be made for Limited Companies through NICs and Flat Rate VAT schemes.

Create a Business Bank Account

By creating a separate bank account for your contractor work, you can calculate your income and expenditure far more easily than having to sift through payments to and from your personal bank account. A business bank account lets you estimate tax payments more accurately without taking up too much time.

Appoint an Accountant

While appointing an accountant may seem another, unnecessary expense – a qualified professional can actually save you time, money and stress. An experienced accountant will be able to answer all of your questions, especially if you have only just started as a contractor, as well as offering additional tax saving advice.

Reducing Your Contractor Tax Bill

There are many ways that contractors and freelancers can save money on taxes through advanced tax planning. Although HMRC rules and regulations apply to all workers and there are no magical means of avoiding tax, a qualified accountant will make sure that you take advantage of all the tax efficiencies available.

Pay Yourself a Small Director Salary

Recent changes to the employment allowance – which refunds employers’ NICs up to a maximum of £3,000 – have identified two optimum salary levels for Limited Company contractors in 2019/20. These represent the most efficient way to draw income from your company:

  • A salary of £8,632 is advised if the director is the sole employee and the company is not claiming employment allowance.
  • A salary of £12,500 may be more tax efficient if your company has more than one employee and intends to claim employment allowance. There are other personal and corporate tax savings to be made here.

Pay Yourself Dividends

Dividends are the main way of extracting funds from a contractor’s Limited Company. However, it isn’t necessarily tax efficient to take all of your company’s profits as dividends, especially as reaching the higher rate of income tax will leave you with a personal tax liability.

Contractors need to understand that timing when they extract dividends can be a useful tax saving procedure – as net dividends can be taken before they reach the higher tax rate thresholds. For 2019/20 there is a dividend allowance of £2,000.

  • On a salary of £8,632 per year, the optimum amount to extract as dividends is £36,840.
  • On a salary of £12,500 per year, the optimum amount to extract as dividends is £33,480.

Pay Salary and Dividends to a Spouse

Many contractors choose to share Limited Company ownership with a spouse or partner, especially if their partner has limited or no other income of their own. It is a legal way of paying less tax – as the partner’s income tax allowance can be taken advantage of and, overall, a lower tax rate can be made on dividends.

Make Use of Company Savings

Contractors can maximise the benefits of having money saved in their Limited Company by:

  • Investing in shares, bonds, and properties in the company’s name to bring tax savings.
  • Taking out life insurance products that provide large tax incentives.
  • Contribute towards a pension scheme that offers two-fold tax relief.
  • Leave money in the company and draw out £2,000 per year tax free once you cease business.

Make Fewer National Insurance Contributions

A key advantage for contractors operating through a Limited Company is the opportunity to alleviate the amount they are paying towards National Insurance Contributions. This can be managed by taking a lower salary from your company and receiving the remainder of your income through dividends.

Claim Tax Relief on All Expenses

A business expense is defined as a cost that is incurred exclusively for business purposes, including equipment, computer software, business travel, accommodation costs, and accountancy fees.

A main benefit for a contractor is that they can claim all business costs as expenses and by doing so will receive tax relief on the amount. Business expenses are deducted from your company’s profit – meaning you pay less on your company’s taxable profit.

Take Out a Pension Scheme

Contractors are responsible for securing their own futures, so it’s recommended they take out a recommended pension scheme – especially as pension contributions bring tax relief by being deducted from your company’s pre-tax profits.

You can reduce your tax bill by £190 for every £1,000 contributed to a pension scheme – and they don’t have any NICs deducted. HMRC has set an allowance of £40,000 per year for pensions savings, which cannot be exceeded, and a lifetime allowance limit of £1,055,000 that is rarely reached. Similar tax savings can be made through healthcare schemes.

Register for a Flat Rate VAT Scheme

As mentioned, a Flat Rate VAT Scheme is used by most contractors to simplify VAT for small businesses. It’s especially useful for companies that provide services, turnover less than £150,000 per year, and incur very few expenses that include VAT.

The Flat Rate VAT Scheme basically means you charge the standard rate of VAT at 20%, but pay back HMRC at a lower rate (14.5% for most contractors) – with an additional 1% discount (13.5%) in the first year of the scheme.

Apply for Entrepreneur’s Relief

Entrepreneur’s Relief is available to contractors who close down their Limited Companies, dependent on certain criteria. It basically reduces the amount of Capital Gains Tax on the disposal of qualifying business assets and must be claimed for in writing to HMRC within a certain time frame.

Claim on Capital Assets

Capital assets, including hardware, laptops, furniture and fixtures for your office, can be claimed as a capital allowance in the first year of purchase – providing tax relief. The amount of allowance, however, is determined by the annual government budget.

Make Savings on Life Insurance

For contractors operating as a Limited Company, Relevant Life Cover can greatly reduce the cost of your life insurance. Purchasing a policy through your business – instead of funding it through taxed income – can save you money on income tax and National Insurance on the cost of premiums, while you still receive Corporation Tax relief. Your policy will be held in trust so that any payouts go directly to your dependents, who will also avoid inheritance tax when accessing funds.

Make Savings on Childcare

A new tax-free childcare system introduced in October 2018 can help contractors save on childcare expenses. As part of the scheme, the government will pay £2 towards every £8 that you spend on registered childcare – up to £2,000 per year.

The childcare scheme is available for children up to the age of 15 (or 16 for children who are registered as disabled), and eligibility is dependent on meeting certain HMRC criteria.

Keep up with Government Schemes and Initiatives

You can make additional tax savings by keeping track of government schemes and initiatives designed to encourage small business growth. The Employment Allowance is an example of a scheme that offers tax relief – by reducing the amount of National Insurance (up to £2,000) that Limited Companies have to pay.

Purchase a Company Mobile Phone

HMRC allows contractors to provide their employees with a mobile phone as a tax-free benefit. The phone can be used for both personal and business use – and you will receive Corporation Tax relief on the expense without any personal tax implications.

Organise a Staff Party

Few people are aware that HMRC will contribute up to £150 per employee – while still receiving Corporate Tax relief – to have a staff party! This only applies to Limited Companies and staff parties can occur at any time of the year (not just Christmas!).

Apply for a Mortgage

While it may be more difficult for contractors to secure mortgages – since some providers only take into account salary earnings and ignore dividend payments – it’s not impossible.

Saving a large deposit, making sure your credit score is high and providing proof of future contracts will help your mortgage application. And, with the rising number of contractors, there are now specialist mortgage brokers offering customised deals for contractors.

Protecting Yourself As A Contractor

Working as a contractor or freelancer may give you more freedom, but there are still some regulations to abide by – and a degree of uncertainty involved. There are several ways that you can comply with business and tax laws, while protecting your business against the unexpected and using funds to your advantage.

Comply with IR35 Rules

IR35 is a government legislation tax that assesses contractors based on their particular work arrangements. It safeguards HMRC against tax avoidance workers who may be disguising their work as contractors – by operating through an intermediary who would otherwise be their employer.

If your business contract is deemed to be caught by IR35 legislation, you will be able to complete the contract – but you won’t be entitled to the same tax benefits as other contractors, and can only claim a small range of business-related expenses.

Recent changes mean that contractors working in the public sector no longer have a say in their IR35 status, which is now entirely defined by HMRC – and come April 2020, the rules surrounding private sector contractors are also changing.

If there is an investigation, contractors can seek Tax Liability Cover (IR35 insurance) to pay for a professional to defend your case, and even cover liabilities if you are found in breach.

Maintain and Record Your Tax Information

Recording details of your income and expenses can be a monotonous task, but it’s important to keep track of your invoices. You need to take note of paid amounts, outstanding amounts and expenses, especially if you want to avoid stress while completing your Self Assessment return.

Submit Your Tax Returns on Time

It is equally important that you submit your tax return on time, especially if you want to avoid unnecessary fines from Companies House and HMRC. There are also penalties for late payments, which can continue to rise if payments remain unpaid, so careful tax planning can save you money.

Protect Your Income

Income Protection Insurance is designed to cover workers during times when they are incapacitated by illness or an accident. Not all standard policies cover contractors, while some policies will pay your gross contract rate rather than your salary and dividends – and can continue paying into retirement if you do not recover. Having protection in place is recommended, especially if you have just started work as a contractor.

Invest in Quality Business Insurance

Whether it is public indemnity, professional liability, business interruption or standard insurance to cover your equipment, taking out quality Business Insurance is a safeguard against uncertainty.

There are specialist contractor insurance firms offering standard packages that will cover all of your business needs – while considering your personal needs through private medical insurance is also beneficial.

Maintain Your Cash Assets

Keeping track of your income and expenditure can be tiresome and confusing, especially for contractors and freelancers. By having an accountant, you can obtain a monthly update of how much money you need to accrue for tax purposes.

Remember, cash is still an asset that can be used to advantage by contractors. Limited Companies should consider using a Business Savings Account that will make use of your funds until the date the tax is due – while Sole Traders can use funds to reduce interest on your mortgage or pay off the loan amount if you have an offset mortgage account.

Use Your Savings as a Safety Net

As a contractor, it is sensible planning to have savings in place should any unexpected circumstances arise, especially if you are just beginning your own business. Having six month’s worth of savings will help new businesses settle, give you the opportunity to seek out preferred contracts, and get you through any lean periods.

You can also use your funds to create an investment portfolio; you can save up to £20,000 a year in an ISA (plus up to £4,368 in a junior ISA for each child) and benefit from tax free growth).

Contractor Accountants & Tax Advisers – Redwood Accountants

There are many tax savings to be made as an independent contractor since freelance workers typically charge more for their services, pay less in taxes and can deduct business expenses.

Contracting through your own Limited Company is the most tax-efficient way of operating a small or single-person business. Contractors are also open to far better tax planning opportunities than employees, which can reduce your overall tax liability and increase your disposable income.

Carefully planning your tax burden with a professional accountant is one of the most dependable ways of saving money on tax by making sure your business takes advantage of all efficiencies to bring success – and you can also claim payments as expenses.