What is an umbrella company?

What is an umbrella company?

Most people embark on a contracting career because they love the idea of being their own boss. For those that cherish flexible professional arrangements, they may misunderstand the benefits of working with an umbrella company and believe this mode of engagement is not really compatible with a freelancing career. This is a misconception, as umbrella companies have an important role to play in the contracting marketplace. If you understand what an umbrella company is and how it functions, you will be in a better position to decide if this business model is right your independent freelancing work.

An umbrella company gives you an alternative route to contracting work if you are unsure about setting up a limited company. Both business models function as an intermediary between you (the contractor) and the client (an agency or employer), with the umbrella being responsible for ensuring you get paid for the work you perform.

Limited company vs umbrella company

The core difference between running a limited company and working with an umbrella is your employment status in the company.

If you operate a limited company, your designation is that of a director and you have different avenues open to minimise your tax liability, as long as you have the ability to manage your finances. On the other hand, if you operate through an umbrella, you are deemed an employee. Hence, you are eligible for National Insurance and PAYE contributions.

That being said, when you engage through an umbrella company, you still keep the freedom to establish your working conditions based on each contract. But, your paperwork and back office administration is taken care of for you. Convenience does come at a small cost, because you will pay slightly higher taxes and also have to be responsible for National Insurance contributions.

How does an umbrella company function?

The working of an umbrella company is simpler than you think. Once you finalise the contract with your client, you will have to maintain a timesheet. This sheet has to be countersigned by your client, and at the end of the month, it is sent to the umbrella company. Based on the number of hours you have clocked, the umbrella will prepare and send an invoice to your client.

The client checks the invoice and releases your payment to the umbrella, which, in turn, will pay you after deducting fee, taxes and National Insurance, if any. You will also get a payslip that will present the entire calculation process for your final payment.

A word of caution

Of course, this summary of how an umbrella company runs is intended as an overview rather than an exhaustive summary of the finer details regarding how they operate. Invariably, there are different methods of running the company based on the services offered. Remember, you cannot enjoy a huge tax advantage the moment you enter PAYE. So, don’t get taken up by an umbrella that promises to help you minimise tax. Also, you should not be under the impression that you can claim your expenses at will, as this is not the case with the new IR35 legislation in place.

As a contractor working through an umbrella, you cannot claim every expense. Anything you spend should have been spent entirely on your contracting work and you have to keep all receipts to justify those claims.

It is prudent to remember that an umbrella company will deduct its fee before tax. This can help bring down your tax liability marginally. The fee can be a fixed amount or a percentage of your total payment. Find out the payment schedule. Some umbrellas pay as soon as the client releases the funds while others pay on a specific date in the month.

In conclusion

There is a misconception that an umbrella company does away with the advantages of being an independent contractor, or you end up paying a large slice of your profits to the company. Working under an umbrella company has many benefits, but those advantages depend on your business goals and individual circumstances. Nonetheless, if you do choose to work through an umbrella, you may enjoy substantial benefits in the long run.

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