What is an umbrella company and how do they work?
There are several payment options for contractors to consider before they begin an assignment. This includes using an umbrella company, which can initially seem tricky to get your head around.
In this article, we’ve explained what umbrella companies are and how they work, as well as a summary of their advantages and disadvantages.
What is an umbrella company in simple terms?
Umbrella companies are used by contractors working on fixed-term contracts as a way for them to get paid for their work with recruitment agencies or end clients. The alternatives for contractors are to join an agency’s payroll as a worker or to setup their own limited company to be paid B2B by the agency or end client. Read more about the differences between umbrella companies, agency PAYE, and limited companies.
Essentially, a contractor can select an umbrella company who then employs them, processes timesheets, and pays their salary which has been collected from the agency or end client. This means they are a third-party supplier, which of course comes at a cost – usually around £100 monthly. However, there are several reasons why a contractor might use an umbrella company which we’ll cover later.
The graphic below clarifies the payment relationship between the involved parties. The umbrella company essentially collects the money and pays the correct salary to the contractor.
If a contractor decides against an umbrella, they will instead be paid by the agency. If a contractor instead decides to work through their own intermediary, often conducted through a personal service company (PSC), the contractor will be paid directly by the client or the agency if they use one.
How do umbrella companies work?
Umbrella companies are intermediaries (or third parties) that pay contractors who complete work for an agency or client. Rather than receiving payment directly from the client or agency, an umbrella will invoice them for this sum and pay the contractor with any necessary deductions like National Insurance and taxes.
Here’s how the process of joining an umbrella company generally works:
- Find an umbrella company ensuring you conduct proper research on its suitability, even if your agency recommended it
- Join through their website or over a call
- Sign a contract with them, and they will sign one with your recruitment agency
- Conduct your work and submit your hours to the client for approval and then the umbrella company to process (plus any allowable expenses)
- You’ll be paid by the umbrella company, who has invoiced the agency or client, with all necessary deductions and expense allowances
- At the end of the tax year, you’ll receive a P60 or P11D and you can reclaim the cost of any remaining expenses
How much can you earn through an umbrella company?
When you join an umbrella company, you are considered an employee and will be paid via payroll. This means National Insurance and income taxes will be deducted, plus pensions if applicable. Income tax will be subject to standard government thresholds based on the salary you earn.
For the benefits of using the service, umbrella companies will take a margin. This is typically around £100 monthly or £25 weekly, which may not be ideal if you’re on a low salary. However, a great benefit of this payment structure is that you are eligible to claim expenses. Bear in mind this depends on the type of assignment and whether it’s subject to legislation around supervision, direction, or control (SDC).
Some agencies may even uplift your contracted rate to offset the cost of using an umbrella company. Limited companies, on the other hand, are more tax-efficient as you can receive a combination of tax-free salary (below £12,500) and dividends. However, you will not receive employee benefits and will be fully responsible for your finances unless you hire an accountant.
What are the advantages of umbrella companies?
- As an umbrella company employs you, you will be under continuous employment both during and after your project. This is great if you’re looking to apply for a mortgage or loan and require stability. If you work for an agency, on the other hand, you will only be considered an agency worker.
- You will receive some statutory benefits including sick pay and parental leave. Some may even provide additional perks like health insurance, life cover, and accident cover. Other benefits may include access to insurances like professional indemnity and public liability.
- You will have one tax code even if you work with many agencies, meaning you’ll have one pay day, one tax code, one pension pot (if eligible), and one P60.
- You can submit legitimate business expenses, depending on whether your contract is subject to SDC legislation. An umbrella offers greater efficiency than an agency for this reason.
- It deals with all administration including accountancy and taxes, reducing your responsibility, and saving you time. Plus, any chasing for payment or timesheets is completed by the umbrella company.
- It’s very easy to get started compared to a limited company which requires set up via Companies House.
- It’s ideal for those contracting for a short period or those who may return to full-time employment in the future. Subject to contract terms, you can leave an umbrella without the process of dissolving a company. You can be up and running in a matter of minutes.
What are the disadvantages of umbrella companies?
- A limited company is more tax efficient as you will be on payroll and will not have the option to choose a mix of salary and dividends. Generally, a limited company will take home more pay, however, there is the consideration of hiring an accountant and no holiday pay.
- You have little freedom under an umbrella company in that you are unable to control how you are paid or how you run your business.
- Few umbrella companies can make dishonest claims about being able to increase your wages or reduce your tax liability. All companies operate under the same compliance legislation, so your take home pay should be similar across all. However, those particularly efficient in keeping up to date with the latest legislation and additional ways to add value may be more appealing. Always do your research and weigh up your options.
- Unlike agency payroll, you will need to pay an umbrella company a weekly or monthly sum. Although this is relatively low, it is a consideration for lower-salaried workers.
- If your contracts fall outside of IR35, a limited company can be more tax-efficient.