Do contractors get taxed more?

There are approximately two million self-employed contractors in the UK and many more employees considering the flexibility of running their own business.

However, there is an element of uncertainty in leaving stable employment, with the risks of a drop in income, and the inevitably complex tax system, with many people concerned about their tax liabilities as an independent contractor.

This article outlines some of the financial pros and cons, looking at:

• What are the advantages of trading as a contractor?
• What are the key differences between contractors and employees?
• How do employee taxes and contractor taxes differ?
• Financial tips for new contractors

Contractors deal with various challenges, such as reduced job security, the absence of employment rights (including paid leave and sickness pay), and a potentially erratic schedule. 

However, some additional tax incentives and government support are available to mitigate the risks of trading as a contractor.

The advantages of working for yourself include:

• Claiming back money for expenses before paying tax
• Having control over your work schedule and hours
• Working with a diverse range of clients
• Choosing your rates of pay and terms

UK law clarifies the three fundamental differences between contractors and employees:

1. Mutual obligation: Contractors aren’t obliged to accept work offered to them, nor do their clients have any obligation to provide work. 
2. Control: Independent contractors can determine their schedules and working days and hours, whether weekly, monthly or yearly.  
3. Substitution: A contractor is entitled to send a substitute to carry out work on their behalf – an employee, an apprentice or a subcontractor, for example (depending on the contract terms).

There are also several tax-related differences, which we’ll explore below.  

The easiest way to define the differences in the taxation system is to look at employee taxes vs contractor taxes.

Employee tax rates in 2021/22

Employees’ income tax rates range from zero, if below the annual earnings threshold, right up to 45% for additional rate earners. The tax-free allowance changes from year to year, and in 2021/22 is £12,570.

Above that:

• Income from £12,571 to £50,270 is taxed at the 20% basic rate.
• Earnings from there up to £150,000 are charged at a higher rate of 40%.
• Additional rate income tax of 45% applies to taxable income over £150,000.

Employee taxes are deducted at source through the PAYE system, plus National Insurance Contributions (NIC) and student loan repayments.

Contractors pay the same income tax against their private earnings, with identical tax brackets – but the eventual tax bill can vary considerably, depending on their trading structure, and self-employment is just one of many options.

Trading options for independent contractor businesses

Most contractors register as self-employed with HM Revenue & Customs, incorporate a limited company, or register an umbrella company.

Contractor taxes for umbrella companies

Contractors who manage their trade through an umbrella company are taxed the same way as a conventional employee. 

Their income after allowances and any deductions (expenses or pension contributions) are subject to standard PAYE calculations, plus the normal employee National Insurance Contributions.

Registering a contractor business as a limited company

Trading through a limited company is a very different scenario and can be more tax-efficient. The taxes associated include:

• Corporation tax: applies to all UK limited companies, charged at 19%. Companies need to submit annual accounts and a corporation tax return.

• Income tax: income received as a salary from the limited company is taxed through the PAYE system reverting to the standard tax bands and rates as above. 

• Employee’s National Insurance: if your company employs you, you will need to manage NIC deductions through payroll. The current NI rates are 12% for earnings between £184 – £967 per week, with 2% on anything above.  

• Employer’s National Insurance: the company will pay the employer’s NIC on your salaried income, at 13.8% on any amount above £184 per week. Most contractors pay themselves a low salary to avoid high income tax and NIC liabilities.

• Dividend tax: contractors running a limited company usually own 100% of the business and can split their income between a salary and dividends, with a balance to minimise tax charges. Dividends are tax-free up to £2,000 and then taxed at a 7.5% standard rate, 32.5% higher rate and 38.1% additional rate.

• Value-Added Tax (VAT): limited companies with revenue over £85,000 must register for VAT and add the correct rate to their invoices. Each quarter, the company must submit a VAT return and pay any differences between collected input VAT and output VAT spent to HMRC. 

Financial tips for contractors – with a focus on efficiency!

One of the best ways for contractors to keep track of their finances is using the right software. Countingup offers many advantages, including:

• Bookkeeping functions – recording all business income and outgoings to make filing tax returns, calculating deductions and submitting accounts far easier.

• Expenses tracking – contractors can reclaim most of the costs associated with running their business and need to maintain accurate logs of all expenditures. Countingup works as a powerful mobile app, where you can scan and store receipts, with transactions automatically entered into your bookkeeping system.

• Tax record-keeping – the combined current account and accountancy tool will keep a log of tax paid and owing, with one-click processes to share your reports with your accountant.

Running an independent business, starting up a new limited company, or branching into self-employment needn’t be a tax headache.

Countingup is the business account with free, inbuilt software specifically engineered to make life easier for contractors and small business owners.

Sign up today and get a three-month free trial to see how this user-friendly, automated app can revolutionise your bookkeeping and make compliance a streamlined part of your trade.