Contractor or employee, what’s the best option?

Some people think that there are many advantages to being a contractor rather than an employee such as large tax advantages or the ability to earn more money.

However, the benefits of being a contractor are not always so beneficial, considering the loss of employment rights and security that employees have. So, are the financial & non-financial benefits of being a contractor still worth it?

This blog explains the pros and cons of being a contractor and the financial benefits that contracting can bring.

Contractor vs employee financial benefits

Let’s look at an example of the financial benefits that a contractor may have over an employee:

Applying the tax rates for 2020/21, an employee earning a salary of £60,000 will take home £43,443. The gross cost to the employer after considering Employer’s National Insurance of £7,067 is at least £67,076.

A contractor operating through a PSC undertaking an outside IR35 contract, with the same earnings of £60,000, could take home £48,245, which is an increase of £400 per month.

Contractors can also negotiate a better rate and increase their earnings as the end client’s costs related to Employer’s National Insurance, pensions and holiday pay is not applicable due to the contractor’s status.

Financial differences that make contracting more financially beneficial

The financial difference mainly stems in from 2 factors:

1. Optimising the level of salary and dividends:

   Contractors can pay themselves a lower salary, usually up to the NI threshold and the rest of the funds are drawn as dividends. Therefore, the contractor pays no National Insurance on £60,000 income (There are no National Insurance contributions due on dividends), whereas an employee pays £5,060 in employee national insurance contributions.

2. Claiming expenses:

   Expenses that are ‘wholly and exclusively’ incurred for business purposes can be claimed by contractors. These expenses are tax deductible and come out from contractor’s pre-taxed income, giving contracting a significant advantage over being employed. As an employee, you bear these expenses from post-tax earnings.

Here’s an example:

Both spend £500 on travel and lunch.

The cost is £500 for an employee as it comes from their net earnings.

The cost is £375 for a contractor as it can be claimed through the company.

When looking at contractors vs employees benefits, there are other financial factors to consider, and we explore these below.

Contractors VAT

If a contractor is registered for VAT, there are clear benefits. Any items that include VAT, they can offset this against their input VAT charged on their invoices. So, for example, a contractor purchases a laptop at £1000 (including VAT), the cost to them is only £833.33.

Charge out rates for contractors

Because a company doesn’t have to pay holiday pay, travel, sick pay, or pension contributions for contractors, it allows most day rates to be much higher than a full-time employee.

Higher hourly rates, even without the other financial benefits, can make contracting more financially attractive to many. However, as a contractor, remember that the higher rates earnt are often justified to cover the risks associated with being self-employed and the loss of employee benefits.

Corporation Tax rises for contractors

Albeit Corporation Tax rates remain static in 2021/22, contractors need to remember that profits over the small profits rate of £50,000 will be caught by a Corporation Tax increase due in 2023. However, good tax planning can reduce contractor profits and allow them to benefit from the small profits rate, so seek tax advice.

What are the non-financial benefits of contracting?

Being a contractor is not always about the financial benefits. Many people become contractors to allow themselves the freedom that contracting can bring to their life.

You need to consider what else is important to you. Is it the freedom to work when you want, where you want and for as long as you want? Often a contractors non-financial benefits are a bigger motivator for contracting than just the money.

Is it better to be an employee because of IR35 rule changes?

HMRC off-payroll IR35 reforms are meaning many contractors are considering their future as a contractor vs employee. Companies that hire contractors, now have the responsibility of assessing the employment status of a contractor and more importantly the tax liability.

HMRC tax liabilities and fines can be very punitive if the employment status is assessed incorrectly, so blanket assessments will be made by businesses to avoid costly mistakes.

If you’re a contractor, we’d advise that before you decide your future, you should talk to your client, gather your own evidence on your employment status and discuss this with your client.

Contractors working within the new HMRC IR35 rules, really need to take this into consideration when deciding if youre better off being an employee.

Employment status can dramatically affect your decision, because those within IR35 are treated like an employee, with the same tax status as an employee but without any of the rights and a loss of some of the contractors financial advantage.

For example, if you’re working within IR35, the rules around business expenses are much stricter. You won’t be able to claim for things like travel to and from work or subsistence if your contract is inside IR35. Again, this takes away some of the financial benefits of contracting that need to be considered.

Contractors using an umbrella company

If you’re a contractor deemed as inside off-payroll, you may work via an umbrella company. Umbrella companies are a ‘halfway house’ between employment and contracting.

Umbrella companies employ workers under an employment contract with all the statutory employment rights, deduction of employment taxes, costs for their insurance; whilst giving them the flexibility and freedom they get while contracting.

Umbrella company can mean you giving away some control but for many, it can make life easier with less worry and paperwork, whilst giving contractors freedom to concentrate more on client work.

Is it better to be a contractor than an employee?

As you can see above, the answer to this question isn’t always simple. It depends on many factors including what you value as an individual.

There can be a difference in both the financial and non-financial benefits, including tax savings, freedom, flexibility, and the potential of more risk and less security.

Using an umbrella company may not give you the same financial benefits as contracting through a limited company. But umbrella companies can be ideal for first time contractors or for those contractors wanting to trial employment once more.

Looking at purely the figures, being a contractor can often offer a better financial return than being an employee.

But, its often its not just the money that attracts people to contracting, add in the non-financial benefits of contracting, like the freedom to choose work, choose clients and the flexibility, contracting still is an attractive option for many people.

We’re specialist accountants to contractors, umbrella companies and small businesses, so we can help you consider the options and find the best solution for you.

Contact us if you need help.

About the author

Sumit Agarwal
Sumit Agarwal (ACMA ACA India), the Managing partner of dns accountants is a highly respected accountant with expertise in helping owner-managed businesses.