The short and simple answer is that a PAYE umbrella company is a company that serves as an intermediary company between a contractor and his or her other clients (who will either be employers or agencies.)
Why does it do this? What is its purpose? Basically, the whole raison d’être of umbrella companies is that they take away the burden of all the admin that is traditionally associated with contracting (things such as invoice administration, taxation and payroll) in order to allow the contractor to concentrate more on their actual contracting work and less on their paperwork. As part of this, the main responsibility of an umbrella company is of course to organise the payment for the work that the contractor carries out. The client pays the umbrella company and then the umbrella company will in turn look after their contractor’s NIC’s and PAYE. Once they have done this they will then pass the rest of the money on to the contractor.
So why do contractors opt for umbrella companies? These days there are essentially two options open to contractors – setting up their own limited companies, or working under an umbrella company. Limited companies certainly have their advantages when it comes to employment status. Contractors who operate through a limited company are directors and are therefore able to make the most of options for tax minimisation that are available to limited companies. They are also the essence of the go-it-alone spirit that most people are looking for when they move into contracting. However, they also come with a hell of a lot of paperwork! As director of a limited company you are taking full responsibility for your own finances, taxes and all the work that goes with it. Umbrella company contractors on the other hand, still have that ‘be your own boss’ mentality but are willing to outsource one bit – the annoying, tedious bit – to someone else.
They still work for themselves in reality, but have got rid of the need to plough through mountains of paperwork and have simply changed their specific employment status. As part of an umbrella company, contractors become an ‘employee’ of the company and therefore must pay NIC’s and PAYE. That is essentially the trade off – a marginally higher tax rate and National Insurance contribution in return for complete freedom from paperwork and admin, which should, in turn, allow a contractor to work and earn more.
How does it actually work? Very easily and simply. Once a contract has been agreed on, the contractor is then simply required to log their ‘working’ time on a timesheet (and this timesheet will then usually be signed by their client.) This timesheet will then be passed on to the umbrella company (most of them are done online these days anyway) and the umbrella company will then invoice their client. Once this invoice has then been settled the umbrella company will then pay their contractor, after they have deducted the correct tax, National Insurance and any fees that they might charge. This will all be detailed on a payslip.
This, in essence is the whole process of working with an umbrella company. There are a lot of umbrella companies out there who say they can offer other services in addition to this but these claims should be treated with caution. For example, many will say they can offer significant reductions in tax. This is unlikely as there is hardly any wriggle room on managing tax liability from within PAYE. The same applies to claims that a company can maximise expenses claims and allow you to claim more than any other umbrella company. Again, there are very clearly defined rules on expenses and it is unlikely that one umbrella company would be able to claim for something that another would not. Claims for expenses are still limited to expenses that are accrued solely and entirely in the fulfilment of the contract and all expenses claims must come with receipts.
There is however some variety in how umbrella companies pay their contractors. Some umbrella companies prefer to pay regularly on a set date whilst others will forward you your money as soon as they have processed it from the client. Some will deduct their fees before you pay tax (which should bring down your tax liability ever so slightly) whilst others deduct it after. Some will charge you a fixed fee whilst others will charge you a percentage of your earnings.
If you’re looking for the most hassle-free way of contracting then there is little doubt that umbrella companies are the way forward. They may take a chunk out of your earnings and offer you slightly less leeway when it comes to tax and expenses but having all of your finances and admin handled by someone else will leave you more time to work on your contracts and therefore more time to be earning money. You won’t get bogged down in paperwork and lose sight of why you went out on your own in the first place. And there’s one other thing – you won’t have to worry about IR35. Working under a limited company means you are always at the whim of the IR35 legislation and whether you are a ‘deemed employee’ or not, for tax purposes. Working for a PAYE umbrella company means this will simply not be an issue that you need to worry about ever again.