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Payment options available to contractors

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When you talk to someone who is looking to contract for the first time, they are likely to ask you “how do I get paid?” This is a complex area, but it is best to know the basics so that you can give a confident response. The resources contained in this section will give you an overview.

Contractors have several options open to them. They could get paid through your recruitment agency, meaning that they submit a timesheet to your payroll department.

They could work through an Umbrella Company, and instead of submitting a timesheet to your agency they send it to the Umbrella Company who then invoice you.

Alternatively, they could set up their own limited company and invoice the end client direct. Once you have described these three options, it is likely that your candidate will ask you "which one is best for me?"

What is an Umbrella Company?

An Umbrella Company acts as employer to the contactor. Traditionally, a lot of agencies would offer to pay candidates themselves if they were not set up as a limited company. However, this means a lot of work for the agency, who would have to validate expenses, ensure that all the required tax and national insurance contributions are being deducted correctly, insure payslips, P45's, P60's, and deal with payroll queries.

Umbrella Companies do all of this on behalf of the contractor, meaning that all the recruitment agency has to do once contracts have been issued is invoice the client, deduct their margin and make a payment for the time worked to the Umbrella Company.

Why might a contractor set up their own limited company?

Some contractors, especially seasoned ones, will operate via their own limited company, often referred to as a Personal Service Company (PSC). A PSC is a company that is managed by the contractor and no-one else (this is important).

The main benefit of this option is that rather than taking all their income as a salary they can pay dividends out to themselves instead. These aren't subject to national insurance contributions (NICs) and avoid the higher rate of Income Tax. However, it is important to have a working knowledge of one piece of legislation - IR35.

IR35 was a piece of legislation introduced in 2000 to tackle tax and NIC avoidance schemes. The view of HMRC was that many contractors were often treated as self-employed when really they should have been treated as employees of the end client, and therefore should have tax and NICs deducted from their earnings. Under the new rules contractors deemed to be within the IR35 regulation bracket will pay tax and NIC as if they are a direct employee of their client.

I've heard about composite companies and Managed Service Companies. What are they?

In the past contractors would often use a composite company, usually a Managed Service Company (MSC) in order to be paid. The contractor would become one of up to around 20 non-director shareholders of the company, which was managed by a scheme provider. They would receive a low salary and take the rest of their pay in company dividends, meaning that each individual would pay a lot less tax and NICs than if they had been paid by a salary. 

When the Government brought in the new IR35 legislation contractors were only able to use Composite Companies if their own circumstances fell outside of the IR35 rules. Since the new rules came into force, however, HMRC alleged that many contractors and companies were ignoring the legislation and still using composite companies via MSCs even though their status was almost always one of being within the IR35 rules.

In April 2007 another rule change was implemented which forced all MSC contractors to pay tax as though they were an employee of their client, effectively ruling all workers using the scheme into an IR35 'caught' position. Therefore, if a contractor is working on a contract caught by IR35 regulations and still uses one of these forms of companies and underpays tax and NICs, he or she is breaking the law.

Can agencies be held liable if a contractor is found to be using an MSC?

Historically, if a company or payment scheme was found to be illegally underpaying tax and action was taken by the HMRC they would liquidate quickly, as they had no assets, and reopen as a new business the next day.

In order to counter this, new legislation in April 2007 created 'debt transfer' rules, which allowed the recovery of underpaid taxes and NICs from appropriate third parties, principally those behind the company operating such schemes including directors, shadow directors and connected or controlling parties.

Therefore, if your agency is judged to have recommended that a contractor operate their affairs in a certain way, you could be caught under debt transfer rules if they are then found to be acting illegally.

HMRC has released guidance that stated that if a contractor's company already existed at registration with the agency then they are unlikely to be liable if the company turns out to be an MSC and will not be caught under 'debt transfer' rules. If the contractor sets up a company after registration it is in your interests to be careful and ensure that they are operating lawfully. Many agencies now ask client's companies to fill out a questionnaire to show due diligence and protect themselves from possible debt transfer repercussions.

What information would I need to see from an umbrella company or PSC if a contractor is working through them?

It would be in your interests to check that the organisation is legitimately operating as a limited company. A simple way to do this would be to either check their company details at Companies House or ask to see a copy of their Incorporation Certificate.

If they are registered for VAT and will be adding it to any invoices to you then you may also want to see a VAT certificate. Some agencies also choose to send questionnaires to companies to ascertain whether they will operate legally, as explained below.

MSC questionnaire - covering yourself as a recruiter

The new legislation on the use of MSCs and the 'debt transfer' rule has been a cause of concern for many recruitment companies. Some agencies have looked to reduce their risk by insisting that all limited companies and umbrella companies complete a questionnaire to make sure they are operating legally and be seen to show due diligence if they are investigated by the HMRC.

The questionnaire would generally try to find out if the company was controlled by any third parties (other than the contractor) and if so, whether the third party controlled the finances and dictates by what methods contractors will be paid. It was also find out whether appropriate levels of PAYE tax and national insurance would be deducted.

This is a complicated area and we would recommend that if you wish to produce such a document you seek legal advice.

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