How do umbrella companies work?

Many contractors now work with umbrella companies, instead of choosing to work as a sole trader or setting up a limited company. Deciding how to run your contractor business is a complex decision and many contractors may not fully understand the process of working with umbrellas. So, let’s dig a little deeper and answer the question: how do umbrella companies work?

There are many umbrella companies to choose from and some promise to save contractors a small fortune in claimable expenses and allowances. You have to tread carefully when making your decision – here are our top tips when choosing an umbrella company.

Before we start delving into the world of umbrella companies, let’s remind ourselves of a key piece of legislation surrounding taxation and self-employment, specifically, IR35.

What is IR35? 

IR35 is a piece of tax legislation governing the taxable income of self-employed workers engaging in ‘disguised employment’ - a process of artificially manipulating your taxable income by working through an intermediary, such as your own limited company.  

In reality, however, IR35 threatens the legitimate income of many contractors, especially those working in the public sector, and can inflate your tax rates and risk sizeable payments in back tax.

Umbrella companies offer contractors a legal way to avoid these taxes, as well as providing administrative services to make your personal and business finances easier to manage.

What is an umbrella company?

An umbrella company acts an employer to freelancers and contractors, turning self-employed ‘members’ into taxable employees.

As employees, people working with an umbrella company are no longer subject to IR35 checks. Instead, you are eligible for standard employee income tax.

Although your umbrella company is your employer, they will not offer you work, post job listings, or help you earn a living in any way. You must rely on agencies or finding your own contacts to secure work opportunities.

Being an employee also affords other benefits typically not afforded to freelancers and contractors. This includes holiday pay, statutory sick and maternity pay, and the option for tax-free workplace pensions.

Umbrella companies can also provide references that prove your history of completed contracts. This commodity is practically impossible to attain for most self-employed professionals. Similarly, the guise of permanent employment is beneficial when it comes to credit checks and other reference-reliant procedures, such as renting a home or office.

How do umbrella companies work? A step-by-step guide

When you sign up with an umbrella company, you will typically go through the following process:

1. Become an employee

First, you need to sign up as an employee with an umbrella company. Deciding which company to partner up with can be a difficult choice, and many will attempt to muddy the waters with grand promises, or minor perks and benefits.

Remember that these are the people between you and your paycheck, so choosing a reputable and reliable umbrella company should be your primary concern.

2. Start working

Whether it be through an agency or directly with a client, once you do the legwork to secure a contract, the next step is to hand that contract off to your umbrella company. The contracts and invoices for the work will be between the client and your umbrella, and it will be their responsibility to ensure all agreements are binding and legitimate.

3. Record timesheets and expenses

Your clients will provide the relevant documentation that prove you work either with an agency or with the umbrella company directly. You will also need to record your deductible and reimbursable expenses, such as travel costs, and send them to your umbrella.

On a contractually-agreed timescale (usually weekly), the umbrella company will be paid for the work you have completed. This includes any reimbursements from the client for expenses you have accrued and notified your umbrella of.

5. The umbrella company pays your taxes and deductions

Through the PAYE system, your umbrella company will pay all applicable taxes to HMRC, as well as deductions like National Insurance contributions and workplace pension payments.

The company may also charge an administration fee, these costs usually average out at around £30 a week.

6. The umbrella company pays you

You will then receive the remainder of your earnings, as well as a comprehensive breakdown of where your earnings have gone. With no need to complete any extra self-assessment, all your money is now yours to spend freely.

In conclusion

How do umbrella companies work? We hope this article has helped answer this question. If you want any further information, head over to our collection of umbrella company guides, or check out our listings of the top umbrella companies in the UK.

Friday 19th Oct 2018