Why contractors should consider setting up a limited company

Why Contractors Should Consider Setting Up a Limited Company

In the UK, more and more contractors are choosing to operate through limited companies rather than working as sole traders or under umbrella companies. This shift is not without reason. For many contractors, setting up a limited company offers a range of benefits that can improve their financial situation, protect their personal assets, and give them greater control over their business. However, there are also certain responsibilities and complexities that come with this decision. Below, we explore the main reasons why contractors should consider setting up a limited company and what factors need to be taken into account before making the switch.

1. Tax Efficiency and Increased Take-Home Pay

One of the primary reasons contractors opt for a limited company structure is the potential for increased tax efficiency. By operating through a limited company, contractors can often take home more of their earnings compared to working as a sole trader or under an umbrella company.

Limited companies are subject to Corporation Tax, which is generally lower than the income tax rates faced by sole traders. As of 2023, the Corporation Tax rate in the UK is 25% for profits over £250,000, with a marginal rate for profits between £50,000 and £250,000. In contrast, income tax for individuals can rise to as much as 45% for higher earners. Additionally, contractors can pay themselves through a combination of salary and dividends, with dividends being taxed at a lower rate than regular income.

This ability to structure payments through a combination of salary and dividends can lead to significant tax savings, allowing contractors to retain more of their hard-earned income.

2. Limited Liability Protection

One of the key advantages of setting up a limited company is the protection it offers to personal assets. As the name suggests, a limited company limits the personal liability of its directors and shareholders. This means that if the company faces financial difficulties or legal claims, the personal assets of the contractor – such as their home or savings – are protected. The liability is confined to the assets owned by the company itself.

For contractors working on large projects or in industries where disputes may arise, this limited liability can provide peace of mind. It ensures that personal finances are safeguarded in the event of unforeseen circumstances.

3. Professional Credibility

In the competitive world of contracting, reputation and professionalism can make all the difference. Operating through a limited company often gives contractors a more professional image. Many clients, particularly larger businesses and organisations, prefer to work with limited companies as it offers them greater security and professionalism.

Having a limited company also signals to clients that the contractor is serious about their business. It demonstrates a level of commitment and organisation that may not be as apparent with sole traders. This can be a deciding factor when competing for contracts, especially with larger corporate clients.

4. Greater Control Over Finances and Expenses

As a director of a limited company, contractors have greater control over their business finances. They can choose how and when to draw their income, and they can take advantage of various business expenses that are deductible against profits. For example, expenses such as office supplies, travel costs, and professional memberships can be claimed as allowable expenses, reducing the overall tax burden.

Additionally, if a contractor needs to reinvest in their business – such as purchasing equipment or software – these costs can be offset against the company’s profits. This level of financial control allows contractors to manage their cash flow more effectively and plan for the future.

5. Flexibility in Retirement Planning

Setting up a limited company also provides contractors with more flexibility when it comes to retirement planning. Contractors can make tax-efficient contributions to a pension scheme through their company, which can help reduce the amount of Corporation Tax paid. Contributions to a pension scheme made by the company are treated as a business expense and can reduce the company’s taxable profits.

This offers a dual benefit: contractors can save for their future while also reducing their current tax liability. For those thinking long-term, this can be an important factor when deciding whether to establish a limited company.

6. IR35 Legislation and Compliance

One of the key challenges contractors face is the UK's IR35 legislation, which aims to prevent "disguised employment" – where individuals work as contractors to avoid paying employee tax rates, despite effectively being employees. Contractors operating through a limited company need to be mindful of IR35, as it can impact how they are taxed.

If a contract falls inside IR35, the contractor must pay tax at a similar rate to employees, reducing the benefits of operating through a limited company. However, with proper planning and advice, many contractors can structure their contracts to remain outside IR35, allowing them to continue enjoying the tax advantages of a limited company.

It’s important to seek professional advice to ensure compliance with IR35 rules and to understand how the legislation applies to specific contracts.

7. Administrative Responsibilities

While there are numerous benefits to setting up a limited company, it’s essential to be aware of the additional administrative responsibilities involved. Directors of limited companies are required to file annual accounts with Companies House and submit tax returns to HMRC. They must also maintain accurate records of the company’s finances and ensure that all necessary taxes are paid on time.

For some contractors, these administrative tasks may seem daunting. However, many choose to work with an accountant or use specialised software to manage these responsibilities efficiently. While the administrative burden is greater than that of a sole trader, the financial and legal benefits of a limited company often outweigh these challenges.

Conclusion

Setting up a limited company can offer significant financial and legal advantages for contractors, from tax efficiency and limited liability protection to enhanced professional credibility and greater control over business finances. However, it’s not a decision to be taken lightly. Contractors must weigh the benefits against the additional responsibilities, including compliance with IR35 and the need to manage company finances and administration.

Before making the switch, it’s advisable to seek professional advice from an accountant or financial adviser to ensure that a limited company structure is the right choice for your individual circumstances. With the right planning and support, setting up a limited company can be a rewarding step for contractors looking to maximise their income and secure their financial future.