Contractors across the UK have two choices when it comes to getting paid when not working through their own limited company. They can either choose between an umbrella company or ‘Pay As You Earn’ (PAYE) agency. To make a decision about which one of these fits their situation the most, they must understand the difference between them.
What is an Umbrella Company?
An umbrella company is an entity that employs self-employed contractors as legal employees. The company provides contractors with several services, such as payroll services, helping with tax deductions, claiming expenses, doing all their paperwork, etc. When working in an umbrella company, a contractor becomes a legal employee of the company.
Umbrella companies provide contractors with an attractive alternative to working through a limited company. It is because when they work through a limited company, they have to comply with some tax regulations, especially the IR35. The IR35 applies to contractors that perform similar work to employees but operate through their own limited companies.
What is PAYE?
‘Pay As You Earn’ (PAYE) is a standard form of income tax in the UK. It refers to when employers deduct income tax and National Insurance Contribution on salaries paid to their employees. Through this system, employees don’t need to worry about paying income tax every month or about national insurance contribution payments. The employee gets a net salary after the employer makes these deductions from their earnings.
The PAYE system is different from tax returns, which individuals pay annually. At the end of each tax year, individuals need to calculate their income tax and pay it according to taxation rules. Any taxes paid by employees through PAYE reduce the overall tax payable by them. At the end of a tax year, employees calculate and pay tax for themselves, while under PAYE, the employer does it for them.
PAYE is one of the most common forms of taxation in the UK. Whether an employee works full-time or part-time, they must pay taxes through the PAYE system. However, anyone who does not qualify as an employee does not have to use the system, for example, self-employed contractors. It is because they provide services less frequently or temporarily.
When a contractor picks the PAYE system, their agency runs their payroll for them. However, if they go with the umbrella company route, the company does it for them. Similarly, umbrella companies also offer other additional services, as stated above.
How does the PAYE system work?
Under the PAYE system, employees have to pay tax based on their annual income. There are various categories with variable tax rates. For example, the basic rate of 20% tax applies to anyone with an annual income of £12,501 to £50,000. Similarly, the higher rate of 40% applies to individuals with a yearly income of £50,001 to £150,000. Anyone with an income above that must pay the additional rate of 45%. Lastly, anyone with an annual income of £12,500 or below is exempt from taxation.
These categories are not fixed but stepped. It means that if an employee is earning £30,000 a year, they will be exempt for the first £12,500 and pay the 20% tax for the next £17,500. Employers must work out the annual salary of an employee at the end of each month. Since the employer must predict the annual income of the employee each month, the amount may vary due to several reasons, for example, bonuses or promotions, etc.
When the amount of estimated annual salary differs, the employer must recalculate the tax for the employee based on the current estimate. If the new estimate is lower than the previous estimate, the employee will receive a refund. If it is higher, then the employee will have to pay the additional amount of tax caused by the increase.
What are the differences in employment in Umbrella vs in PAYE?
Regardless of whether a contractor chooses to work under an umbrella company or chooses a PAYE agency, they will need to pay tax. For the umbrella company, the employee has to pay tax through the employer, which in their case is the company. The umbrella company also deducts the same amount under the PAYE system and submit it to the government. As mentioned, the umbrella company takes care of the deductions and processing of those amounts.
Contractors also have another option, which is to pay through a PAYE agency. A PAYE agency also recruits a contractor as an employee and deducts any relevant taxes or other payments from their net paid amount. When it comes to the process, both PAYE agencies and umbrella companies have similar procedures for deducting taxes.
Since the payment system and taxation regulations are the same under both options, employees have to pay the same tax regardless of in which one they opt to work. There is no difference in the income tax rates under both systems. Therefore, the pay that contractors get under both systems should theoretically be the same.
The main difference between the two is how they treat the contractors that work for them. When working with PAYE agencies, contractors are considered their employees. These agencies decide which contracts the contractors get and which they don’t. Similarly, they process the contractors’ salaries through their payroll.
On the other hand, an umbrella company also employs contractors. However, they do not choose who contractors work with or if they get contracts or not. They allow contractors with much better control over the contracts on which they want to work. However, umbrella companies still process contractors’ payments through their payroll.
Since under both systems, contractors are considered employees, they receive all the related benefits associated with being an employee. For example, employees get sick pay, holiday pay or maternity leaves. Any other benefits or rights related to employees of other companies also apply to contractors working through either of these options. However, some PAYE agencies don’t classify contractors as permanent employees, so these benefits may not always be available.
Lastly, another difference in employment under both systems is that of continuous employment. When working through an umbrella company, contractors are classed as being in continuous employment from the first day of their contract, even if they work on various contracts, for several agencies and clients. It means that even though they work for multiple agencies, these contractors will have a single employer and tax code.
What are some other differences between umbrella and PAYE?
Besides the primary differences in employment, there are some other variances between both the systems as well. Firstly, when working through umbrella companies, contractors can claim income tax relief on business expenses, such as travelling, accommodation, food, etc. A list of all claimable expenses is available here. However, working through PAYE, the options are not available.
Contractors can also get insurance benefits through both choices. However, with PAYE, sometimes the option may not be available based on the agency that the contractors choose. On the other hand, umbrella companies even cover additional insurance, including accidental cover and health cover, which comes with no extra cost to the contractors.
When it comes to costs, there are no costs directly associated with working through agency PAYE. However, these agencies may uplift the contracted rate of a contractor if they choose to work with an umbrella company. When working with an umbrella company, contractors have to pay a fee for the services these companies render. However, the cost is usually negligible compared to the services provided by these companies.
Usually, both employers provide support to contractors when needed. The quality of the service does not depend on which route or option contractors choose. Instead, it depends on the specific company or agency they select. However, the income source of PAYE agencies is the end client while for umbrella companies, their source of income is the contractors they serve. So, the advice or support provided by umbrella companies may be more favourable for contractors to follow in some circumstances.
Which one is better?
Whether choosing an umbrella company or a PAYE agency is better for a contractor depends on their needs. However, in most circumstance, umbrella companies are more advantageous. For example, if a contractor intends to avoid the regulations set by IR35, then they must choose umbrella companies. It is because these companies provide contractors with similar flexibility and freedom while also offering better security and a range of employment benefits.
Similarly, for contractors looking to work with multiple recruitment agencies at the same time, then umbrella companies are the way to go. As mentioned above, umbrella companies also provide certain employment benefits, which PAYE agencies, sometimes, cannot. In both these cases, umbrella companies are the better option.
When it comes to extra expenses borne by contractors, such as travelling or accommodation, during the course of their work, umbrella companies also provide them with an advantage. As stated, contractors can claim these expenses, which they can’t with PAYE agencies. Lastly, when it comes to support on contract-related issues, umbrella companies also are beneficial for contractors.
If none of the above issues matters to a contractor, then they can choose to go with PAYE agencies instead. However, that does not imply that umbrella companies are not an option for them.