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Contractor pay types explained – what is an umbrella company?

  • Publish Date: Posted almost 2 years ago
  • Author: Jessica Tabinor

​Making the transition into contracting can seem like a big step but there are now more opportunities for contractors than ever with companies turning to them to plug the skill gap that they are currently facing.

Before you start there are a number of important decisions to make, one being what pay type is best for you. In our new blog series, we will guide you through the different pay types, their key points and also the advantages and disadvantages of each option.

Read on to find out more about contracting through an umbrella company…

What is an umbrella company?

Contracting through an umbrella company or provider can be a hassle-free alternative to contracting as a limited company.  Working under an umbrella company means that all your invoicing, paperwork and payroll processing will be handled by them. But it is important to understand that contracting through an umbrella company does not come with the same tax benefits as contracting through a limited company. Important: Your umbrella company will deduct PAYE and NIC’s from your salary, as technically they are your employer. However, if you pass an SDC test, you could be eligible to obtain some tax relief on relevant expenses. Choosing an umbrella company as a pay option is typically suitable if you are undertaking a short-term contract.

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What is an SDC test?

The Supervision, Direction or Control (SDC) test is used by HMRC to determine a worker's employment status. A worker's SDC status is used to decide whether or not they have their income tax deducted through the Pay As You Earn (PAYE) employment status. The test is also used to determine an umbrella contractor’s eligibility for tax relief on expenses. To be eligible for tax relief, you must pass the SDC test, which will often be provided by your umbrella company.

Advantages of contracting through an umbrella company:

  • Easy set-up, simply choose your preferred company and provide them with the necessary information and start contracting.

  • All paperwork and administration is handled by your umbrella company.

  • You are entitled to all statutory employee rights.

  • Potential to receive tax benefits on relevant expenses.

  • Perfect for the short term, first-time contractors or contractors who have failed IR35.

Disadvantages of contracting through an umbrella company:

  • You must pass an SDC test to be eligible for tax benefits.

  • Your employment status will be listed as PAYE, which means you could pay the full tax and National Insurance Contributions.

  • Not an ideal option for long term or experienced contractors.

How do I choose the right umbrella company?

There are many umbrella companies out there to choose from, at Morson we work with several approved suppliers to help you find the right umbrella provider. You can find more about them here.

How do I claim my expenses if I am an umbrella contractor?

In normal VAT accounting if you incur an expense you will fill in an expense claim form and provide copies of relevant receipts, then send the form and receipt to your employer. Your employer will then refund the expense to you along with payment of your hours and account for the VAT accordingly.

If you are a VAT registered contractor and have passed the SDC test, then you could be eligible to claim back the tax on expenditure.

The example below is for a hotel bill of £120.00 including VAT

Hours: £1000.00

Hotel Net Amount: £100.00

Total VAT @ 20%: £220.00

Total Invoice: £1320.00

The VAT amount including the £20 VAT on the hotel bill will need to be paid over to the HMRC as output tax. However, you or your umbrella company will be able to use your original receipts to reclaim the input tax on the hotel bill. 

What is input tax? Input VAT is the value-added tax added to the price when you purchase goods or services that are liable to VAT. If the person or business that is buying is registered for VAT they can deduct the amount of VAT paid from his/her settlement with the tax authorities.