Umbrella companies have become more prevalent in the UK over the past few years, since the introduction of the IR35 rules. They are regularly used by thousands of agency contractors, largely for administrative purposes.
In this blog we will consider how umbrella companies work, along with their pros and cons.
What is an umbrella company?
Although there is no statutory definition of an umbrella company, according to HMRC “it is generally accepted that an umbrella company is a company that employs temporary workers who work at different end clients’ premises.”
Umbrella companies do not act as recruitment agencies. They neither source work for contractors, nor do they find employees for companies. Instead they facilitate the overall contract, acting as an intermediary between the contractors, the end client and occasionally a recruitment agency.
The main purpose of an umbrella company is to manage the employment and payroll of contractors, whilst helping to protect end clients or recruitment agencies from being caught by IR35 liabilities.
How do umbrella companies work?
Contractors will be officially employed by the umbrella company. They should be provided with a contract of employment and will be endowed with the standard array of employment rights such as maternity pay and sick pay, etc.
Separately, there will be a contract between the umbrella company and the end client. Or in some cases, between (i) the umbrella company and the recruitment agency and (ii) between the recruitment agency and the end client.
The umbrella company will be paid by the end client at a contractually agreed rate for carrying out the defined services, which may be a one off project or ongoing services. Alternatively, the umbrella company will be paid by a recruitment company which, in turn, will be paid by the end client.
When the umbrella company receives payment from the recruitment agency or end client, it will retain a certain amount of money for itself, typically:
- an agreed administration fee;
- the amount they need to pay in National Insurance contributions (NICs) for each contractor;
- holiday payment and allowable expenses; and
- certain other amounts which relate to specific costs (e.g. apprenticeship levy).
The rest of the money is paid by the umbrella company to the contractor as their gross pay. This is then subject to PAYE deductions, i.e. Income Tax and NICs.
Since all employees are entitled to an individual written payslip, umbrella companies are legally required to provide their contractors with itemised payslips. These normally provide a breakdown of payment received by the umbrella company from the agency, including the amount retained by the umbrella company (e.g. its administration fee and employer’s NICs*).
There will be separate details of the contractor’s gross pay and various deductions.
* Including the employer’s NICs on this payslip is known to cause confusion for contractors who think they are paying these. HMRC notes that this is normally a misapprehension and that employer’s NICs are deducted from the payment the umbrella company receives from the end client or recruitment agent. It should be noted that umbrella companies cannot by law deduct employer’s NICs from a worker’s gross pay.
The alternative to umbrella companies: setting up a limited company
Rather than using an umbrella company, many contractors instead decide to set up their own limited company (often called a Personal Service Company or PSC when set up for this purpose).
This essentially cuts out the middle man and saves on costs which would otherwise be retained by the umbrella company. However, this entails extra administration and may also lead to problems relating to the IR35 rules (see below).
Setting up a limited company is very straightforward and can be completed in a matter of hours, particularly if it is done through a company formation agent such as 1st Formations, who has a range of company formation packages at different price points.
IR35 and umbrella companies
What is IR35?
Over recent years a significant number of companies have tried to convert a portion of their workforce from employees to contractors, often for tax avoidance purposes. To counter this trend, the government has introduced various pieces of legislation which aim to prevent employers classifying a member of staff as a contractor when, to all intents and purposes, they are an employee (a practice known as ‘disguised employment’).
The IR35 rules (also known as off-payroll working rules) came into force in 2000 and clamped down on the general practice of disguised employment. However, this did not prevent Managed Service Companies (MSCs) from continuing the practice of disguised employment (i.e. whereby an intermediary company – an MSC – essentially puts distance between the ‘employer’ and the ‘disguised employee’). So the government also introduced MSC legislation in 2007, which deemed all payments received by a worker working through a MSC to be employment income.
Reforms to the IR35 rules came into force in April 2021. These reforms could make end clients more wary about dealing directly with contractors who set up their own limited company.
Are umbrella companies affected by IR35 and MSC rules?
Contractors who are concerned that they could fall under Management Service Company legislation can either set up their own limited company or work via an umbrella company. This will normally be enough to establish themselves as falling outside the MSC legislation.
However, setting up their own company will not normally deal with IR35. Although other measures which can be taken, e.g. taking on more clients and ensuring that any contract with the sole/primary client is not too restrictive and does not reflect an employment contract. Umbrella companies are generally a safer option in terms of IR35.
But some umbrella companies can also fall foul of the tax rules, so care should be taken when using one. A recent government warning about rogue umbrella companies notes that:
“Some people that are employed through agencies and umbrella companies are signing up to arrangements that claim to save them tax, but are in effect tax avoidance schemes.
Most employment agencies and umbrella companies operate within the tax rules. However, some umbrella companies and agencies promote arrangements that claim to be a ‘legitimate’ or a ‘tax efficient’ way of keeping more of your income by reducing your tax liability.
These arrangements leave you at risk because you are ultimately responsible for your tax affairs and for paying the correct amount of tax and National Insurance contributions.
These types of arrangements are likely to result in you paying additional tax, interest and perhaps penalties, and are never HMRC approved.”
There are several warning signs, for example: if the umbrella company says the contractor can keep 80%+ of their wages; or if only a fraction of the salary is paid through PAYE. See this HMRC guidance note for more information.
Umbrella companies vs Personal Service Companies (PSC)
So should a contractor use an umbrella company or set up their own PSC? Here are a few matters to take into account:
- Contractors working under a PSC have no employment rights. But as an employee of an umbrella company, they benefit from all the protections afforded by employment legislation (e.g. access to holiday pay, sick pay, maternity pay, etc).
- Running a PSC involves more administration than working for an umbrella company; annual accounts need to be filed, along with the confirmation statement and corporation tax return. On the other hand, the owner of a limited company has a lot more control over how it is run.
- Subject to IR35 rules, taking money out of a limited company is generally more tax efficient than working for an umbrella company which is subject to PAYE. Furthermore, there are administrative fees which are taken by an umbrella company, reducing the overall amount which would otherwise go directly into the pocket of the contractor.
- Umbrella companies will sometimes be favoured by end clients, as they are generally more wary of dealing with PSCs due to IR35 complications. However, it is important to ensure that the umbrella company is legitimate and following all the tax rules.