It’s been a tough couple of months for umbrella companies. First there was a government crackdown on questionable tax avoiding practices, then there were stories of umbrella firms going bust, and finally revelations of dodgy practices (used by some umbrellas) to circumvent the national minimum wage. Perhaps now would be a good time to explore exactly what is happening to the ‘umbrella’ industry.

First off, let’s explain what we mean by the term ‘umbrella company.’

Umbrella companies are used by contractors who want to work flexibly but without having any administrative responsibilities – such as calculating tax liabilities, managing contracts etc. Instead a company is used as the middle man between them and the client for whom they are performing the work. The client pays the umbrella, and they, in turn, pay the contractor minus tax.

There is a fee for using an umbrella company and these rates vary. As a result, the financial benefits of using umbrellas is rather questionable (they can ultimately lower your take home pay): some charge a percentage of your earnings while others charge a fixed weekly/monthly rate for using their services. It’s also less tax efficient than running a limited company.

For this reason, a number of umbrella companies began using dubious methods of lowering a contractors tax paying responsibilities. A number of firms popped up which promised take home pay of 80-90 per cent. These worked by paying contractors via offshore EBTs (Employee Benefit Trusts) which, in effect, were loans which never had to be paid back. And which didn’t get taxed!

Over the years, a number of coded threats were made to these tax avoidance set-ups, but up until the end of last year nothing had been done. In December, the coalition Government announced that these loopholes would be closed by accounting for EBTs as a payment of employment income, forcing the employer to account for PAYE accordingly.

Another shady practice performed by some umbrella companies was accounting for their minimum wage requirements through paying out subsistence expenses (rather than travelling expenses), classifying workers as directors, and under-recording hours worked. HMRC are none-to-happy with this and are set to take “appropriate action” against such practices and force them to pay the arrears.

The reason many freelancers and contractors decide to work through an umbrella company, is in the belief it offers a secure way of contracting. Presumably, it’s the fear that if they accounted for tax themselves they might mess it up, but with an umbrella it’s all done for them. With a go-between, they hope to wash their hands of any accounting responsibilities – unfortunately, this approach can backfire, as the recent closure of umbrella companies’ Sunday Solutions and Bradbury & Co. revealed.

These two companies handled an estimated £80m for their 1,500 clients, yet none of that money ended up in the hands of the taxman, according to the insolvency company. As a result, HMRC were forced to go after the contractors for the required tax – despite the fact they’d effectively already paid (well they’d paid the middle-man).

By the way, neither company was registered with Companies House and both were charging excessive fees which in many cases amounted to 30% of earnings.

Now, it needs to be said that trusty umbrella companies do exist, but none can safely provide a contractor or freelancer with optimum tax efficiency (as provided by a limited company), so it pays to be suspicious of those which promise high amounts of take home pay. And, as the above example shows, if the company has financial difficulties, the individual worker will be affected.

That’s why we believe running a limited company is the safest, and most suitable option for contractors. Sure, if you’re only going to work as a self-employed person for a short one-off contract, then maybe working as as sole trader or through an umbrella company might be a better option. However, for those freelancers or contractors looking to remain self-employed for the foreseeable future, and are making a good regular pay, then running a limited company is likely to be the best option.

To find if running a limited company is most suitable option for your business, give one of our friendly advisers a call on
0333 311 8000.