Contractor tax issues can be fraught but there are some very clear rules that will help you keep a monthly budget, pay the most favourable rate and make sure you remain on the straight and narrow with HMRC.
Tax rules for contractors
The type of income tax a contractor must pay depends broadly on what type of business they have set up for themselves. Contractors who work under an umbrella company have the least admin to do as they’re paid as traditional employees, through a PAYE system that takes out their National Insurance and income tax.
If you’re running a limited company, the tax regulations are more complex. As you will see, there are tax deductions for self employed contractors available and these too will depend on your personal circumstances and the way in which you choose to receive your profits.
As of 2017, all limited companies are subject to tax at 19% of their net profit, which is payable 9 months after the end of the tax year. You can work out the extent of your contractor taxation by calculating your total yearly profit and subtracting your company’s business expenses, accountancy fees and employee salaries. This is the total that will be taxed. Unlike an employee paying tax under PAYE system, a limited company is never taxed after gross income and revenues.
Employer’s National Insurance Contributions (Class One)
As the director of your limited company, you’ll be subject to Employer’s NIC, which is set at 13.8% on your gross salary. It is payable on amounts over £11,500 per annum. If your company employs anyone other than yourself and you pay a salary above the personal threshold, your company could be eligible for Employment Allowance, which offsets £2,000 from the total Class One NI payment required.
Higher tax for contractors can be avoided if you follow this basic rule of thumb – aim to pay yourself a director salary that is between the Primary Threshold for NI (£157/week) and your personal allowance (£11,500) and then take the rest of your salary in dividends. You shouldn’t avoid paying any National Insurance entirely as these payments safeguard your state pension and other benefits triggered by NI.
Contractor Income Tax
Your director salary is subject to the same PAYE (Pay As You Earn) taxation as any other job. If you earn over your Personal Allowance of £11,500 then you will be taxed at the following rates:
- 20% (basic rate – up to £45,000)
- 40% (higher rate – up to £150,000)
- 45% (additional rate – over £150,000)
What does my tax code mean?
Tax codes are usually a combination of numbers and letters. The numbers refer to your tax-free allowance (you find the total by multiplying the number by 10) and the letters refer to how you’ll be taxed. There are exceptions to this rule and for a complete breakdown you should refer to HMRC.
The most common tax code is 1150L
1150 = £11,500 personal allowance (1150 x 10)
L = Standard personal allowance
Another common tax code that contractors can find themselves under is BR.
BR is usually applied to contractors who have just left employed work and set up their business. BR stands for basic rate and means that the contractor has no personal allowance and all income is charged at the basic 7.5% rate. This is usually because HMRC thinks that your business is a second income. Once your p45 has been processed and it’s established that your business is your only income, you’ll usually be reassigned to the 1150L tax code.
Contractor Dividend Tax
Dividends are the way in which the vast majority of limited company owners receive their contractor income, as long as they are not caught by IR35 legislation. Up until April 2018, the tax-free dividend allowance is £5,000, but, due to a major shake-up in the way dividends are taxed, after April 2018, the tax-free allowance falls to £2,000 per year.
The contractors tax rate for dividends depends on the level of income tax you pay and is structured as follows:
- 7.5% (basic)
- 32.5% (higher)
- 38.1% (additional)
How do I work out how much my dividend income will be taxed?
Put broadly, the equation for working out what portion of your income will be taxed is:
Gross salary + other income + dividend – personal allowance.
Let’s say that your limited company pays you a basic salary that both triggers National Insurance payments but puts you just under the personal allowance for income tax – £11,500.
You take the rest of your monthly income in dividends, which come to £60,000, making your total income (salary + dividends) £71,500.
Let’s say that your tax code is 1100L. This means you earn £66,500 over your personal allowance (£71,500 – £11,500 = £66,500)
Pre April 2018, your tax-free allowance for dividends is £5,000. This means £55,000 of your income is subject to tax.
Post April 2018, your tax-free allowance for dividends is £2,000. This means £58,000 of your income is subject to tax.
Let’s assume £55,000 is subject to tax.
You pay 7.5% basic rate tax on income up to £33,500, which comes to £2,137
You pay 32.5% higher rate tax on all income over £33,500 and up to £150,00, which comes to £8,612
Your total dividend tax bill is £10,750.
Value Added Tax (VAT)
If your annual turnover is more than £85,000 then your company must register for VAT. It is likely that no matter what your turnover, your accountant will advise you to register for VAT because of what you can claim back on business-related purchases. For instance, if you buy a laptop solely for work use, you can claim back the 20% VAT you paid on the total cost. To pay VAT, your company must invoice each client at the standard rate of 20% of the total fee. The VAT collected is then due to be paid to HMRC every quarter.
How do contractors pay taxes?
If you are an individual running a limited company, you will need to fill out a contractor tax return. This means that you or your accountant must fill out a self assessment and make your tax payment by January 31st each year. You must do this online once you have registered with the HMRC portal.