The main reason why I made the jump from a permie role into full-time contracting was the chance to at least double my earnings. The increased autonomy, freedom, and lack of office politics were all important factors, but the main driver was the financial reward, without a doubt.
So, after taking the leap into contracting, the last thing you want to do is give away too much of your hard-earned cash by working in a non-tax efficient way.
If you are taking the time to read this, you have probably already decided to operate via your own limited company, rather than choosing the umbrella company route. For me and many, this is a sensible move as contracting via a limited company is often regarded as the most tax efficient way to work.
When I first went contracting, the thought of setting up my own company seemed ridiculous at first – a world away from the relatively comfortable life I had as a data analyst for an FTSE 100 company. However, I soon realised that limited company contractors are not a minority group. In fact, quite the opposite is true.
Of the 1.3 million UK limited companies, around 550,000 are run by sole directors, and a fair proportion of these companies are used to provide contracting services to clients.
Assuming your contracts don’t fall foul of the IR35 rules, the average contractor on £300 per day could be £10,000 better off by setting up a company compared to the umbrella route.
It’s important to say that tax is a famously complicated subject, so I’d strongly urge you to hire an accountant to help. Here, I share what I’ve learned and experienced over the years about drawing down money from a limited company, and how to do so in the most tax efficient way possible. Please don’t just take my word for it; make sure you chat with an accountant and get their advice.
The basics of withdrawing money from your limited company
As a permie, you earn an annual salary and typically get paid once per month, net of tax and any other deductions (such as pension contributions).
As a limited company contractor, things change a fair bit from a tax point of view. Put simply, the company has to pay tax on its profits, and you have to pay personal tax on anything you draw out of the company. This means that limited company contractors have to pay Corporation Tax of 20% on all our profits plus personal tax.
After you allow for deductions for expenses (such as accountancy fees, salaries, or computer equipment), the company’s retained profit may be distributed to its shareholders via dividends. Unlike traditional ‘employees’, no National Insurance contributions (NICs) are payable on dividend distributions.
I’ve always thought that it is fair to gain a tax benefit from working via your own limited company, as contractors are not provided with any ‘employee perks’, and are effectively running small companies, with all the associated risks, hassles and challenges.
Setting your salary level
Unless you have a contract of employment with your own company stating otherwise, you have no legal obligation to draw a salary at all.
However, as your salary is deductible against the Corporation Tax liability of your company, it is wise to draw a salary. For example, my better half takes care of all the office administration and deals with my accountant, so the company pays her a modest salary for her troubles.
Thankfully, it is easy to set your salary level. My accountant helped me set this up for my wife, and she was up and running as an employee in no time. Many other contractors do the same. One thing to bear in mind though, as many an accountant has told me, if you’re paying your spouse a salary, they do actually need to do some work.
How do you pay yourself a salary?
Unless you decide to take on your company’s accounting duties yourself, most contractors hire accountants to take care of their tax obligations.
I’ve met a few ‘hardcore’ veteran contractors who resented paying anyone to do their accounts for them. I always thought that this was a false economy, as you’d need not only a certain amount of specialist knowledge, but also a fair bit of time to keep on top of your accounts, keep up with changes to the tax laws, and meet all your company’s tax deadlines.
There are some contractors who are able to keep on top of their accounts, but they are few and far between from my experience. For most contractors, especially first-timers, hiring an accountant is a must.
I would probably not have made the move into contracting at all without knowing that a professional firm was taking care of my company behind the scenes.
One of the first tasks an accountant will do when you start out as a contractor is to set up the company’s payroll. You (and any other ‘employees’ of the company) will receive payslips, just as you did as a permanent employee. You then transfer the net salary from the company’s business bank account to your personal account.
I remember receiving the P45 from my final permanent employer in the late 1990s and taking great pleasure of handing it to my new accountant. One of the most liberating things about contracting is being in charge of your own tax and business affairs for the first time.
What about dividends?
As a limited company contractor, you will draw down most of your company’s retained profits as dividends. And, interestingly, your own company’s dividends are treated in exactly the same way as any other UK company. The most important rule you must abide by before declaring company dividends is to ensure that the company has sufficient retained profit to cover them. Your accountant should be the first port of call if you have any doubts at all about a number of dividends you wish to declare.
Dividends must be paid to shareholders according to each individual’s shareholding. For most contractors, this is usually 100% (for a sole shareholder), or 50% each for joint shareholders (such as spouses).
I’ve met some contractors who seem to treat their company’s finances as their own, including splitting dividends with their partners, without making the necessary changes to the share structure first.
One guy (an Oracle DBA) I worked with simply took £10,000 or so out of his company whenever he felt like it. He said it was his money to do with as he pleased. I’m not even sure that he had an accountant. He was a disaster waiting to happen!
What about the paperwork?
No-one’s keen on paperwork as such, but with dividends, there are several housekeeping tasks you need to keep on top of.
Once you have decided upon a figure to distribute amongst the company’s shareholders, you must record the decision via board meeting minutes. You must then issue each shareholder with a dividend voucher, which records show the net and gross dividend amount paid to them. The voucher itself can be physically sent to each shareholder, or you can simply attach the voucher to an email.
I’d highly recommend physically creating the board meeting minutes and vouchers right away, otherwise, your paperwork can become out of sync fairly quickly (and that’s before you remember that it is a legal requirement to complete the paperwork on time!)
Even better, a decent accountant – well mine did anyway – will provide the dividend templates for you.
How are dividends taxed?
When I started out as a contractor, dividends to me seemed a little confusing. But quite simply, you are taxed on the gross dividend you declare, rather than the net dividend. So, when you work out the dividend taxes you are liable for, you should use the gross sum.
If you distribute £10,000 of retained profit to the company’s shareholders, you multiply this amount by 10/9 to give a gross dividend of £11,111. Dividend tax is applied to this gross amount, after allowing for a nominal 10% tax credit, which applies to all dividends, from any UK company.
I found this concept hard to grasp when I first ran a limited company but soon realised that the tax credit is provided to make up for the fact that the company has already paid Corporation Tax on its profits.
You pay your dividend tax liabilities via the self-assessment system. This means you have to fill in a tax return each year, and submit it by 31st January.
If you want to submit your tax return online, rather than using an accountant, one bit of advice from personal experience is to make sure you apply to use HMRC’s ‘online services’ with plenty of time to spare, as, without an activation code, you won’t be able to do so.
What is IR35?
IR35 has caused more stress to me and to contractors I’ve worked with than all other challenges combined. To operate tax efficiently, one thing to ensure as a limited company contractor is that your contracts do not fall foul of the IR35 legislation.
IR35 was created to clamp down on ‘disguised employees’ – essentially IT workers who have set up limited companies, whose working practices are still more akin to employees rather than self-employed.
In order to remain safe from IR35, your physical contract must state that you are working as a self-employed individual, and the way you actually perform your contract must also demonstrate that you are not an employee in disguise. An entire IR35 service industry has evolved since the rules became law, including employment status experts, firms who can check over your contractors to ensure they comply with IR35, and insurance providers.
I’d say, above all – make sure you get all your contracts reviewed by an IR35 expert. My accountancy firm also specialises in contract reviews so I was able to speak to my accountant and get this reviewed swiftly.
To make the most out of your hard-earned contract income, as a limited company owner, you have a fair amount of tax planning opportunities – both over how you time your dividend declarations, and also how you structure your company shareholdings.
I’ve had experience of accountants since I first became a contractor back in 1998, and what they say is very true – a good accountant will become your most trusted advisor over time.
The three most useful pieces of advice I received from past accountants on the subject of taking money out of a company are:
a) Whatever you do, make sure you have enough profits in your company accounts to cover any dividends you declare.
b) Put aside a proportion of your dividend income each time, to allow for your income tax liability, which arises on 31st January each year.
c) Keep accurate records, such as dividend vouchers and board meeting minutes. You never know when you might need to produce them.
You may also find our Contractor Take Home Pay Calculator useful – simply enter your daily or hourly rate into our simple calculator, and see how much you could be taking home through your own limited company.
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If you would like to know more about how to take money out of your limited company, give us a call on 01442275789 or fill in the form below.