How Tax Works When You Set Up a Limited Company as a Contractor

Limited Company Contractor Tax: Understanding the Basics

Getting to grips with how tax works when you set up a limited company as a contractor can be daunting, but it all makes a lot more sense when you understand the basics. When you form a limited company, it becomes a separate legal entity from you as an individual. This separation is key to how tax is applied, and it’s what makes limited company contractor tax different to sole trader tax.

Instead of all income being taxed personally, your limited company earns income from clients, and then your limited company pays Corporation Tax on its profits. You pay yourself via salary or dividends, or a mix of both, and you then pay personal Income Tax on your earnings.

In order to do this, you need to register your limited company with HMRC, file annual accounts with Companies House, submit a Corporation Tax Return and operate PAYE if you pay yourself a salary. At the same time, you need to submit a Self Assessment Tax Return as an individual covering your salary, dividends and any other income.

What Tax Do Limited Company Contractors Need to Pay?

As a limited company contractor, you need to deal with multiple types of tax. Each one applies differently, with its own deadlines and rules. 

Corporation Tax

Corporation Tax is paid by your limited company on its taxable profits. Taxable profits include contract income, interestand any other company income, minus allowable business expenses, salary payments, Employer’s National Insurance and pension contributions. Corporation Tax is paid 9 months and 1 day after the end of your business’ accounting period.

Income Tax

As a limited company director, you are technically an employee of your own company. This means you need to pay Income Tax. Most contractors choose a low salary, often around the National Insurance threshold to qualify for state pension years, minimise Income Tax and NICs, and keep more profit inside the company. Your salary is subject to PAYE, deducted before Corporation Tax and taxed at standard Income Tax rates.

National Insurance Contributions (NICs)

There are two types of NICs to consider. Employer’s NICs, which is paid by the company on your salary above the secondary threshold and Employee’s NICs, which is paid by you personally on the salary you earn above the primary threshold. Dividends do not attract NICs, which is why many contractors tend to prefer them over taking a larger salary.

Dividend Tax

Dividends are paid once Corporation Tax has been deducted from the business’ profits. Once dividends are paid, you can use your Dividend Allowance, and any excess is taxed at dividend tax rates based on your Income Tax band.

Value Added Tax (VAT)

You must register for VAT if your limited company’s taxable turnover exceeds the VAT threshold in a 12 month period. Some contractors register voluntarily to appear more established, to reclaim VAT on expenses and to use the Flat Rate Scheme. VAT responsibilities include charging VAT on invoices, filing VAT Returns, and paying or reclaiming VAT quarterly.

Tax Rates for Limited Company Contractors

With a number of different tax types to pay, you need to be aware of the different rates, as they’re not all the same. The more you understand the tax rates for limited company contractors, the easier you’ll find it to put money aside to cover tax bills.

Corporation Tax Rates

• 19% on profits up to £50,000
• 25% on profits over £250,000
• Marginal relief applies between these thresholds

Income Tax Rates

Your salary as a limited company contractor is taxed at standard Income Tax rates after the Personal Allowance, which is currently £12,570. Contractors often structure their salary to stay within the tax free allowance or lower bands, so that’s something you can consider.

Dividend Tax Rates

After the Dividend Allowance, basic rate band dividends are taxed at a lower rate than salary, and higher rate bands apply above this. Dividend tax is usually lower than Income Tax plus NICs, which is why this approach remains popular amongst contractors who want to operate in a tax-efficient way.

The Pros and Cons of Limited Company Tax

There are a number of benefits that come with contracting via a limited company, one of which is tax-efficiency. For many contractors, setting up a limited company leads to higher take-home pay, as long as you keep on top of everything. The benefits include:

• Greater tax efficiency through income planning
• Not having to pay NICs on dividends
• Gaining the ability to retain profits in the limited company
• More control over when you pay tax
• Access to a broader range of allowable expenses

Of course, with advantages come disadvantages, and there are a few you need to be aware of.

• Increased administrative workload
• More complex tax rules
• Higher responsibility for compliance
• IR35 legislation risk
• Accountancy costs

For contractors with stable income, the tax benefits of setting up a limited company often outweigh the downsides.

Do Limited Company Contractors Pay Less Tax?

It’s not set in stone or a guarantee but yes, many limited company contractors end up paying less tax. This is because salary and dividends are taxed differently, expenses lower taxable profits, and income can be cleverly timed across tax years. This all tends to lead to a lower tax bill, and more money in your pocket. However, if you’re caught up by IR35 rules, you might lose a lot of those tax advantages. Plus, if you have a high dividend income, you still might be subject to higher tax rates, which reduces a lot of the savings.

Avoid These Limited Company Tax Mistakes

If you want to run a limited company that’s financially stable, you need to avoid the common mistakes contractors make. Even experienced contractors make costly errors, so don’t assume you’re immune to the pitfalls.

Not Planning for Tax Bills

One of the biggest mistakes is failing to put money aside for Corporation Tax and Income Tax, which can lead to cash flow problems.

Paying Too Much Salary

Don’t make the mistake of assuming that paying yourself a high salary automatically means enjoying more money, as you might end up paying more tax. High salaries trigger higher Income Tax and NICs.

Paying Dividends Without Profits

Dividends can only be paid from retained profits, not future income, so don’t make the mistake of paying the wrong amount, at the wrong time.

Claiming Invalid Expenses

There are a lot of expenses that can be claimed as a limited company contractor, but you can’t claim for everything. HMRC penalties apply for non-allowable claims, so don’t claim for something HMRC won’t allow.

Ignoring IR35

IR35 rules affect how income is taxed and should be reviewed for every contract. Don’t assume you’re inside or outside IR35 without double checking.

Missing Deadlines

Tax payments have strict deadlines, and they vary from one type of tax to the next. Late filings result in penalties, interest and increased HMRC scrutiny, so it’s important to pay on time.

Running a limited company as a contractor gives you control, flexibility and potential tax savings, but only if you understand how the tax system works. From Corporation Tax and VAT, to dividends and NICs, each element plays a role in your overall tax position. If you want to be a successful contractor, it’s a good idea to combine smart planning with professional advice. This will help you to stay compliant, whilst also maximising your take-home pay.

At Go Limited, we know how confusing tax can be, especially if you’re trying to juggle both contractor tax and limited company tax. But, once you have a rough idea of how things work, you can build on your knowledge. With our help, you’ll be a limited company tax expert in no time.