The Contractors Guide to Freelancing in the UK

Once you have secured a contract you will need to decide the best way to work.

August, 2003 -- Once you have secured a contract you will need to decide the best way to work. Over recent years contracts have tended to be shorter and contractors often find themselves on a lower hourly rate than what they may have been on in the past. It is therefore important that you maximise your income and avoid any additional costs.

Recent estimations suggest that around 80% of contractors are caught by IR35. Since April 2000, anyone who was working via an intermediary, such as a company or partnership, was caught by new rules if they failed the 'IR35 test'. The Inland Revenue tests contracts to determine which category of contractor the IT worker falls under. Computer contractors are either deemed (a) genuine contractor or (b) 'akin to employed'. (A) If workers are a genuine contractor, i.e. passed IR35, they can continue to pay themselves a small salary and take the rest of their income in the form of dividends, which do not incur national insurance contributions. (B) If they fail IR35 and are deemed 'akin to employed', that is, they appear more like an employee than a genuine consultant; they can no longer take dividends from the company. In comparison to the first method, this will result in a reduction of approximately 8-15 % on their net income.

Until the introduction of IR35 most IT contractors formed their own limited companies where the contractor acted as both director and employee of their own limited company. Today the tax advantages of running a limited company have diminished depending on whether a contractor falls under the new "IR35" rules or not. A small number of contractors who fall outside IR35 continue to run limited companies. Limited companies cost around 100 to set up. Company suppliers advertise in local trade press or contractors can apply for a limited company direct from Companies House. Some accountants may set up a company free on the condition of the contractor signing up.

Other contractors may opt for sole trader status meaning that the contractor and the business are legally and financially responsible. The majority of agencies refuse to deal with sole traders as the Inland Revenue's approach has consistently been that IT contractors are not genuinely self employed and, as a result, must be either an employee of their own company or, via a PAYE contract, with the agency.

A few agencies allow contractors to become PAYE through their own payroll service. This is the least tax beneficial option available to the contractor as full tax and National Insurance (NI) must be paid on all earnings. Furthermore such an option does not allow for business expense claims which normally help reduce tax and NI liabilities.

Some contractors have been tempted by various 'off the peg' solutions to avoid IR35 including setting up offshore companies and employee benefit trusts (EBT's) Such schemes are wide open to attack from the Inland Revenue and are best avoided. Many contractors have discovered that these 'Quick fixes' have exposed them to large tax liabilities, penalties and interest.

After IR35 was introduced the number of EBT's Employment Benefit Trusts grew. November saw changes in legislation surrounding Employee Benefit Trusts (EBTS) and many have welcomed the decision. The trusts were vehicles through which remuneration and other benefits were paid directly to employees. They were designed to minimise tax liabilities of employers and employees. Evidence has shown that some are being used to avoid paying income tax and National Insurance. EBT's should be avoided, as they provide no legitimate opportunity for mitigating any tax. With the recent collapse of EBT's schemes many contractors have lost their hard-earned money.

Following on from EBT's are composite companies whereby the employees are paid as well as being shareholders. The Inland Revenue are currently investigating such schemes and it is at present unknown how the Inland Revenue will treat employees in a composite company. It is thought that contractors who received over 5% of the share are liable for IR35. The Inland Revenue may look on the contractors as innocent employees who have not understood the situation properly; they may demand the tax back or see the contractors as evading tax.

Today the majority of contractors benefit from working through umbrella companies which provide a ready-made invoicing vehicle for contractors whilst also removing the administration duties. The umbrella company issues invoices on the contractors behalf, collects payments from clients or agencies, calculates tax and N.I contributions before paying the contractor their net pay directly to their bank account.

Similar to these, are managed companies that offer similar facilities to 'umbrella' companies but with additional benefits such as holiday and sick pay. The charges for this type of service are normally based as a percentage of gross invoiced income, to reflect the level of benefits provided.

Length of contract, hourly rate and the location of the job may effect the contractor's decision of how to work. The most important thing is not to be caught by IR35 or 2003 could be an expensive year for the contractor.