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How Contractors Work
Becoming an independent contractor is an exciting and potentially lucrative way to make your living. However, unlike a more traditional employee, a contractor is entirely responsible for every aspect of their business. If you want to start working as a contractor it’s important to make sure that you know the basics, including how to define contractor work, and how to register as a contractor.
As anyone who has been self-employed will tell you, there are many perks to working as a contractor, not least that you get to determine exactly how you navigate your working life: negotiating your own hours, setting your fee and choosing your clients. However, life as a contractor also has its own particular challenges – it will be your sole responsibility to manage your finances and advance your career.
The speed of your success can depend quite heavily on the industry that you’ve chosen to work in. Tech workers often find that the demands of their industry lend themselves nicely to the short term nature of contracting work. It’s not surprising that an increasing number of people choose to become an IT contractor over traditional employment.
To help you make a smooth transition into your contracting role, we’ve gathered together contractor advice from the experts, and guides to common issues.
We look at the life of a contractor vs an employee, registering as a contractor, whether or not you need to start a limited company, and tax advice for the PAYE contractor. You’ll be up and running before you know it!
Frequently asked questions
What is the definition of a contractor?
In the UK, a contractor is a person who provides skills or services without being directly employed by any one client. By definition, contractor jobs are not permanent; they last for designated blocks of time, which can vary from one day to several months.
Working as a contractor means you can offer your skills on a business-to-business basis and move very quickly, securing jobs within days rather than having to go through the lengthy recruitment process experienced by a permanent employee. A self employed contractor is paid a designated day or hourly rate and would expect their contract to come to an end on a mutually agreed date, which is confirmed in a formal written agreement. Limited company contractors often use specialised agencies to secure jobs, something which is not an option for sole traders due to Section 134 of the Income & Corporation Taxes Act 1988.
Often, an independent contractor will work under a self employed contract. The main advantage of working in this way is that self employed contractors tend to pay less tax than their employed equivalents and can take home a greater percentage of their gross fee. A self employed contractor is not paid through PAYE and is responsible for their own contractor tax and expenses. Employment rights for self employed workers are not nearly as comprehensive as they are for traditional employees, with only limited protections afforded. However, contractors can be classed as employees if they engage the services of an umbrella company, who handle their tax responsibilities much like a traditional employer.
In understanding the definition of a contractor, it’s equally important to know what they don’t do – there are several very similar employment terms that appear to cover the same ground but mean something different.
The difference between a freelance worker and a contractor is that while both types of workers have to deal with the HMRC directly, a contractor typically works on site for one client at a time. The classic example of this would be an IT contractor. IT contractor jobs are usually centred around a particular project or to fill a gap in the company’s skill set. In contrast, a freelancer usually works from home, can take on several clients at once, often without a formal contract and typically specialise in jobs in the creative industries such as copywriting or editing.
The key difference between a contractor and a consultant is that though both are highly skilled knowledge workers, contractors are usually brought in by clients to address a specific project or skills gap. Contractor pay is drawn at either a daily or hourly rate and then once the project is over, they will move on. A consultant’s work structure is different: they’re usually paid on a monthly retainer or a high day rate and while they will probably not work on site or every day, they are on-call anytime the client needs them.
How do I set up as a contractor?
If you’re looking to set up a company, the first thing you have to do is legally define the type of business you intend to run. This is not about what industry you’re in, instead it’s about thinking how you intend to source your clients, the structure of your working life and how involved you want to be in the tax and administrative side of your contracting business. In the first instance, you have two options: registering as a sole trader or setting up a limited company.
Self employed or limited company?
Sole traders are rare in the contracting business as various taxation laws make it difficult for them to work with agencies. Agencies require you to be a limited company because otherwise they are liable for any lost taxation you might incur. In addition, clients are often reluctant to engage a sole trader as it leaves them vulnerable to considerable cost if, in the event of an Employment Tribunal, contractors attempt to claim employees rights.
Setting up a company as a self employed sole trader is easy and this is its key advantage. It’s also not a binding decision – you can register as a limited company at a later date, should you wish to do so. To become a sole trader, all you have to do is register with the HMRC, something that can be done immediately. You can contact HMRC and declare your intentions by visiting their online portal or by calling the HMRC Newly Self Employed Helpline on 0300 200 3504.
Once you’ve set up a company and you’ve sorted your legally required business bank account and insurance, you can begin to seek out clients. You might do this through agencies, contractor job forums or approaching prospective clients directly. Make sure you have a sharply written CV tailored to each client’s expectations and be prepared to do a lot of networking!
How much should a contractor charge?
It’s the question every first-timer asks: how do I work out an hourly rate for my services that properly reflects my worth? It’s not as simple as converting a salary to a contract rate because unlike a traditional employee, you’ll be responsible for a whole host of costs and taxes specific to running your own business. A contractor salary has to include all your expenses and benefits. It is important therefore that you work out a rate that is sustainable and allows you to remain competitive in your marketplace.
Working out your hourly rate involves a series of calculations that ensure you quote neither too high nor too low. The first thing to do is to calculate how much of your income will disappear in the form of insurance payments, pension plans, travel, umbrella company costs and taxation. Obviously, your contract rate cannot go below this base figure and you should be ambitious about setting your final daily rate. Here are some things to consider:
- Your skill set – do you have any niche skills that make your presence more valuable?
- Your location – contracting in London and the South East will fetch the most competitive rates.
- Your experience – the longer you have been working in your chosen field, the more income you can potentially claim.
- Your industry – IT contractor rates will probably look a lot different to farm contractor rates – it sounds obvious but there’s a lot of misinformation online and it’s important to make sure your research is industry-specific.
You will find talking to your colleagues helpful when you’re working out your own contractor rates. Find out what people with similar skills charge and then take this information to several different agencies. Learning to negotiate early on is a big step in how to maximise your income effectively. Sound agencies out as regards their going rate – remember that their goal is to make their margin as large as possible. It’s your job to make sure that their offer to you is just as lucrative – working as a contractor means that you cannot afford to underestimate your worth. Add a fixed amount to their quoted figure and see if they accept it. Regardless of their response, take the same offer to a several other agencies and gauge the average reaction. This will give you an idea of the general parameters of your industry and ensure that your quote is both fair and reflective of your talents.
What do you need to become a contractor?
The leap from permanent to contract work can be daunting but if you’re properly prepared, it can be a relatively easy process. There are four main areas that you need to consider if you’re contemplating how to become a contractor: clearing your work schedule, finding work, establishing your payment structure and making a contingency plan.
Clearing your work schedule
The nature of contract jobs in the UK mean that opportunities can arise very quickly and you can find yourself signing a contract within days of hearing about a job. If you are still in regular permanent employment, you’ll find it incredibly difficult to pivot at the speed you need to get the best jobs. There are exceptions, but it is usually essential for a contractor to have left their permanent job before they start a contracting business.
To find work quickly, you need to establish a network of contacts and have a high-impact CV that establishes your value in the contractor marketplace. You can contact employment agencies that deal with contractors, use online job boards and utilise your existing networks. You also need to think about where you will concentrate your efforts – for a UK contractor, contracting in London offers the greatest variety of jobs and is the most lucrative option, but you can make a decent living working elsewhere as long as you research the job market.
Establishing a payment structure
Becoming a contractor means deciding what kind of business you want to run. Whether you choose to work with an umbrella company or run a limited company, you will need to establish your IR35 tax status so that you pay the correct amount to HMRC.
Making a contingency plan
As every UK contractor knows, when you run your own contracting business, you are solely responsible for every aspect of your personal and professional life, including providing yourself with holiday pay, sick pay and a pension. Before you start working as a self employed contractor, you need to know how you’re going to take care of yourself when you’re not working. Work out your bare minimum rate by taking account of both your regular monthly expenses and what you have to put aside for leaner times.
How to get paid as a contractor
The way you get paid as a contractor will depend on what type of business you have set up for yourself. You will have either joined an umbrella company which will invoice the client and pay you themselves, dealing with all the tax deductions for contract workers, or you will be a sole trader/limited company and you’ll have to invoice your client for your contracting work yourself. Your invoice will be based upon the payment terms you have agreed with your client.
What is meant by payment terms?
Payment terms refer to the time period you’ll allow for the client to pay the money they owe you. The law assumes 30 days payment terms, but you can specify a shorter turnaround than that: anything from 7 to 14 days are standard payment terms for contractors. Some clients even agree to paying contractors upfront – it just depends what you can negotiate. The payment cycle process can be long, especially if you’re dealing with a larger company who have complex payroll practices, so it’s in the interest of both you and your client to raise invoices as soon as they become due. It is standard practice that you agree payment terms in advance.
Making an invoice is not too difficult – you can even search and download invoice templates online. There are several important elements that your invoice needs to contain.
- Your company’s name and registered number (you can find this on your certificate of incorporation)
- If you are VAT registered, a unique identifying number (this can be anything you like but must be sequential with all other invoices that you raise)
- Your contact details and those of the person/company you’re invoicing
- The date the invoice was issued
- A ‘tax point’ (the date you actually supplied the services you’re invoicing for)
- The full amount you’re asking for, with hours and rates clearly defined and a short description of the work e.g. ‘IT contracting services’
- VAT rate
- Any reference number (also known as a PO Number) given to you by the client
- A list of expenses (including VAT) if any have been agreed beforehand
- How you’d like to receive your money and the appropriate banking details
- Your agreed payment terms
The list above is particularly applicable to contractors who get paid after the work is completed but you may have negotiated different payment terms with your client. If you’re on a job that is likely to last a lengthy period, you can invoice for your time once a month, even if the job is not yet completed. Recruitment agency payment terms mean you will get paid regularly, either weekly or monthly – make sure to check how your agency handles things before you start your assignment so that you can plan your finances accordingly.
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