Umbrella Company And IR35- A Basic Guide

The use of an Umbrella company by companies increased rapidly following the Inland Revenue (now HMRC) issuing bulletin IR35. In simple terms, this bulletin introduced proposed modifications to tax law that decreased tax avoidance by men and women that labored as contractors instead of becoming a worker of the company they worked for. The bulletin has become widely recognized as IR35.

The launch of the rules outlined in IR35 decreased the range for higher paid workers of companies to setup as contractors (still working for the same company) by creating limited businesses and drawing small incomes and taking the majority of the income as dividends, reducing their tax and National Insurance payments. Effectively, IR35 setup a number of tests to determine whether a person is a true contractor or perhaps a disguised employee from the company they are working for (client company).

Each time a contractor agrees a contract having a client company, whether or not it's directly or through a hiring agency, there are risks that it may fall within the scope of IR35 and the contractor may be treated for tax purposes as being an employee of the client company.

This is where the Umbrella company comes into play. The contractor is (or becomes) an employee of the Umbrella company that will bill the client company (or recruitment agency) for the time worked and any legitimate costs sustained. On payment being received by the Umbrella company they'll compensate the contractor, subtract and account for tax and National Insurance. The costs will probably be taken into account when determining the pay out, tax and National Insurance for that contractor.

Contractors who acquire work through hiring agencies have marginally different agreements. There are additional steps in the process that entails the agency is invoiced by the Umbrella company, the agency invoices and is paid off by the client company and the agency then pays the Umbrella company.

Contractors working for an Umbrella company can clearly show that they're not an employee of the client company and consequently do not fall foul of the IR35 rules. The Umbrella company bills the contractor a fee for the provision of their services and this is an allowable expense for tax purposes.

An illustration of how a contractor is paid via an Umbrella company works is best shown:

Contractors who don't work through Umbrella companies need to handle all of the additional paperwork, manage the invoicing and also account to HMRC for tax and NI. Additionally they may face investigation for the breach of IR35 rules. Suspected breaches of IR35 rules are complicated and expensive to fight. Even if you successfully show that you simply haven't breached the IR35 rules, you cannot reclaim the expenses you've accrued.