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  • Writer's pictureMike Evans

Limited Company vs Self-employed vs Employed

Between Brexit and changes to IR35 legislation, the contracting space is looking uncertain at best so many contractors are weighing up their options and considering a change. Going back to a stable salary with paid holiday can look attractive but it’s sometimes very hard to compare an annual salary and a day rate. This article should help you compare your options and consider which situation would work best for you.

*All figures used in this article are based on estimates and use the 2019/20 tax rates. They are intended as a guide only and it’s always advisable to consult an accountant before making a decision.

Converting a day rate into a salary

Some people might be tempted to simply use [day rate x 5 days per week x 52 weeks per year = equivalent salary] to work out an equivalent salary but this is a very unrealistic scenario. In all likelihood, a contractor will work closer to 40 weeks per year due to time between contracts, sickness, holidays and contract disputes so 40 weeks is a much more realistic starting point. 40 weeks a year is an intentionally conservative estimate to take into account the extra time and expense of being a contractor rather than an employee. Using this method will also give an easy calculation of [day rate x 200 = equivalent salary] so a £200-day rate would be roughly equivalent to a £40k salary and a £ 500-day rate would be roughly equivalent to a £100k salary.

Up to around £50k per year, this calculation alone will often be sufficient but when higher rate tax is a factor, you have more to consider:

If you were offered £80k for a year of work and a choice of whether you take that pay through a limited company as a self-employed person or as an employed worker then which would you choose? (Most businesses will not offer these terms but it just serves us in this situation to show the tax implications). The way the money is taxed is very different but when you factor in costs like insurance and accountancy fees that are necessary if you’re not an employee (and higher if you have a limited company), there probably won’t be more than 5% difference between them in terms of take-home pay.

The real tax benefits of running a limited company are that you have the flexibility of leaving money in the business. This means that you could take £50k out of the business rather than taking everything to stay under the higher rate tax threshold. This could still leave you with over £47k in take-home pay and you’d have £11.5k sitting in the business that could be invested or could serve as a buffer for when you’re between contracts. Some of our clients have even used this tactic for several years to build up a larger balance then taken a year off to travel without any drop in income (see the full case study here).

Earning over £100k

If your day rate is £500+ then the ability to keep money in the business becomes even more important. After £100k, you’ll start to lose your personal allowance (the £12,500 you can earn before you start to pay income tax) so your effective tax rate jumps from 40% to 60% between £100k-£125k. Due to this a £125k salary would yield just £76k in take-home pay but if this was paid into a limited company you could pay yourself £50k, take home £47k of it and you’d have almost £50k still in the business for use in future years. In that situation, you could even look to use those reserves in the business to contribute to a pension making your income even more tax-efficient (to learn more about contributing to a pension from your ltd company click here). So if you can get by on less than you earn, you could make huge tax savings by operating as a limited company.

Other points to consider

• Running a limited company will take up time.

Depending on your circumstances, you may need to do bookkeeping, look for new contracts, make tax payments, compare insurance quotes, meet your accountant, get contract reviews or do VAT returns.

• A limited company allows you to split income to make huge savings.

If you have a partner earning less than £50k then you can make savings in tax by bringing them into the business either by paying them a small salary or by making them a shareholder so that dividends are split. If we used the example above of £80k in income, and your partner looks after the children so has no income. They could help out with some admin in order to justify a tax-efficient salary of about £8-10k and have 50% of the shares. This would mean that instead of taking home £47k and leaving £11.5k in reserves, you could each take home £32k (combined, that’s equivalent to a salary of around £96k).

• It’s harder to get a mortgage as a contractor.

Lenders will always favour an £80k salary over £80k of income from your limited company and they’ll usually want at least 2 years of accounts for that income to count so if you think you might need a mortgage in the next 2 years, it might not be the best time to go contracting.

• How important is job security, holiday pay and healthcare to you?

If you have good relationships with your clients, you get unsolicited job offers and are happy to take holidays when you’re between contracts then these employment benefits might make very little difference to you. If however, you’re taking contracts just because you need the money and feel stressed by the thought of where the next contract will come from, taking a pay cut to go to a salaried position might not be so bad.

• When will you pay tax?

Some people really struggle to save a portion of the money they earn through their limited company for tax and end up with a bill they can’t afford so maybe employment would be more suitable. On the other hand, a money-savvy individual could take advantage of the delay between earning money and paying tax to invest income and make further savings.

• How much money do you need?

If you get by on half of your income and tend to invest the surplus or simply leave it in a current account for a rainy day then a limited company might be a great option for you to make further tax savings. On the other hand, the ability to control your income to stay under the £50k higher tax threshold is irrelevant if you need £70k to maintain your lifestyle so a limited company might not be as beneficial.

*All figures used in this article are based on estimates and use the 2019/20 tax rates. They are intended as a guide only and it’s always advised to consult an accountant before making a decision.

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