There is no getting away from it – tax in the UK is complicated. However, this guide aims to break down the deductions you can expect to see from your pay as a contractor and hopefully give you a fuller understanding of what’s going on with your money.
First, we will break down how tax works through an Umbrella Company – often the first destination for a contractor and certainly the easiest. Next, we will touch on how tax is handled through a Limited Company. Being paid through a Limited Company tends to be the most tax efficient way to be paid, although this depends on your personal circumstances – see our Umbrella vs. Limited guide to see which is best for you.
Tax through a Limited Company
This is a little more complicated, since your Limited Company will pay you both a salary – as an employee – and dividends – as a shareholder. It is also required to pay Corporation Tax on its profits. Managing the different thresholds and tax rates for optimum tax efficiency is one of the main reasons you pay a specialist contractor accountant, like Dolan Accountancy!
Salary is calculated as above. It is extremely common to be paid a salary which falls below the 0% income tax threshold, with minimal or no National Insurance being due.
Corporation Tax is paid at 19% on all profits a company makes. Profits are the income of a company, minus salary paid and any expenses incurred in running the business (for more information on tax-exempt business expenses, see our contractor expenses guide).
VAT is charged on all invoices you issue for services and goods provided. This is a fixed rate of 20%. Contractors are usually registered on the Flat Rate VAT Scheme, which means that you charge VAT at 20% on your net invoices, but only repay it at 16.5% on your gross invoices. The difference is counted as profit for the purposes of Corporation Tax, but usually still adds up to a net saving.
Dividend Tax is payable personally on profits paid to you as dividends, from your Limited Company. There is a £5,000 tax free threshold for dividends, no matter your total income. Dividends that fall into the lower rate are taxed at 7.5%; 32.5% for dividends in the higher rate and 38.1% for dividends in the additional rate.
The different forms of taxation related to a Limited Company can be complicated and interact with each other in different ways. Don’t be afraid of the different terminology! Drawing money from a Limited Company in the most tax-efficient manner is the bread and butter for any good contractor accountant.