Contractor guide to take-home pay
Take-home pay is the net amount of income received after the deduction of taxes, national insurance, benefits and voluntary contributions from your pay. For a contractor, this means the amount of your invoice value that you receive after your tax liabilities are taken care of.
While take-home pay is important, it shouldn’t be the only factor in choosing how best to operate as a contractor, writes Joanne Harris, technical commercial manager at contractor accountancy firm Nixon Williams.
Take-home pay (continued), including what affects it
Indeed, compliance with legislation and paying the correct amount of tax are also important to avoid nasty surprises later down the line! Getting caught up in a tax avoidance scheme, even unintentionally, can prove very costly in the long-term, so contractors should treat claims by schemes that claim to be able to ‘boost your take-home pay’ with caution.
You should know that factors which can affect take-home pay include the structure a contractor uses (for example, as a limited company director or an umbrella employee), the amount of expenses claimed, IR35 status and a contractor’s pay rate. Therefore, it’s essential for contractors to understand how to work as tax-efficiently as possible to maximise take home pay.
What kind of contractor are you?
Contractors typically have three options when accepting a contract:
- Become an employee of the agency or end-client,
- Work though an umbrella company;
- Operate via their own limited company.
Let’s address Option 2 first. Using a compliant umbrella company will mean becoming an employee of the umbrella company. As an employee, your pay will be subject to the usual PAYE tax and National Insurance (NI) deductions.
An umbrella employee may receive slightly more take-home pay than an employee in Option 1, because the umbrella company will calculate any tax relief on allowable business expenses where the contractor is not subject to Supervision, Direction or Control (SDC). However, this should be the only difference. If you are seeing anything other than the tax relief on legitimate business expenses, this should ring alarm bells that the structure isn’t a conventional PAYE umbrella company.
Next, Option 3. Typically, and assuming the contract is outside IR35, operating through a limited company will mean a higher take-home pay than working as an umbrella employee because of the tax efficiencies that a limited company can offer.
Working through your own limited company means you have more control over how you pay yourself, allowing more opportunities for legitimate tax planning, which can lawfully maximise take-home pay. Limited company directors also have a wider range of expenses that they can claim tax relief on.
As a general rule of thumb, it is more profitable to do business as a limited company if you are earning more than £35,000 a year, paying yourself through a combination of salary and dividends to ensure you are operating at peak tax efficiency.
The IR35 effect
If you decide to operate through your own limited company, the IR35 status of your contract will have the biggest impact on take-home pay.
The IR35 legislation has been around since 2000 and seeks to ensure that contractors that are working in the same way as an employee, pay broadly the same amount of tax. Essentially, in the absence of the intermediary, would the relationship between the end hirer and the contractor be one of employment? If so, the contract will be regarded as inside IR35 and the tax benefits are reduced.
When the legislation was introduced, the responsibility for determining the IR35 status of each contract always fell on the contractor. In April 2017, this changed in the public sector and the responsibility shifted to the engager. This meant that, for the first time, the decision was taken out of the hands of contractors. HMRC has announced plans to extend this to the private sector from April 2020. For contracts with medium-large organisations, the responsibility will shift from the contractor to the end-hirer.
At the time of writing, the concern is that engagers with little experience of the IR35 legislation will make ‘blanket’ determinations (declaring all contractors as inside or caught by IR35). The effect would be that contractors who genuinely believe their working relationships are outside of IR35 could be forced to work inside IR35, with PAYE tax and NI deductions made from their pay. The changes to the legislation will not prevent contractors from operating through a limited company if they wish, but an inside IR35 determination will have a significant impact on their take-home pay.
It’s imperative that contractors are well-informed as the draft legislation for April 2020 outlines a Client-Led Disagreement Process. If you believe your status determination is incorrect, you should make representations to your client and they must respond within 45 days with either a new decision or confirmation of the reasons for their decision.
With the IR35 changes happening imminently, contractors need to be prepared. Being knowledgeable about the incoming IR35 legislation will mean they are able to challenge incorrect status determination statements. Securing a contract outside IR35 means more opportunities for tax planning, so the take home pay can be higher. Yet, there are some benefits of operating inside IR35 and working through a limited company, rather than opting to take on a full-time role as an employee.
At present, take-home pay should be slightly higher via a limited company operating in the private sector because extra income can be generated through the Flat Rate VAT scheme. You also only pay PAYE tax on 95% of your earnings, with the additional 5% intended to help limited companies with running costs. However, the April 2020 reforms sees the removal of the 5% allowance.
Take-home pay is one of the main considerations for contractors looking at how best to operate and manage their income. But remaining compliant with legislation needs to be at the forefront of any decision-making when thinking about how to put money in your pocket.
Knowing your personal tax liabilities and where you fall within IR35 legislation, particularly during periods of change, can be a complex process but seeking support and guidance from a specialist contractor accountant can really pay dividends, particularly in the long-term.
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