Accounting for Contractors

Contracting in the UK offers flexibility and often higher day rates than permanent employment, but it comes with accounting responsibilities that permanent employees never have to think about. Whether you operate through a limited company, an umbrella company or as a sole trader, getting your accounting right is what keeps more of your earnings in your pocket.

Choosing your structure

Most contractors operate through one of three structures:

If you are earning above £50,000, a limited company is usually the most tax-efficient option – provided your contracts fall outside IR35.

IR35: the elephant in the room

IR35 is the informal name for the off-payroll working rules. These rules determine whether a contractor is genuinely self-employed or whether they would be an employee if engaged directly.

Who determines IR35 status?

Since April 2021, for medium and large private sector clients, the end client determines your IR35 status, not you. For small private sector clients (within the Companies Act small company limits on turnover, balance sheet total and employees, as applied to the off-payroll rules), the contractor still makes the determination.

Inside IR35

If your contract is inside IR35, the fee-payer (usually an agency) must deduct Income Tax and National Insurance before paying you. You are effectively taxed as an employee. In this situation, an umbrella company is often simpler than running a limited company, since the tax advantage of a PSC disappears.

Outside IR35

If your contract is outside IR35, you can take advantage of the limited company structure – paying yourself a combination of salary and dividends to minimise your overall tax and NIC burden.

Key factors HMRC considers

Always get a written status determination from your client and keep it on file.

Contracting through your own limited company? Start your free trial.

Tax-efficient pay: salary and dividends

For contractors operating outside IR35 through a limited company, the standard approach is to pay yourself:

1. A salary at or near the personal allowance – this uses your tax-free allowance and, above the Lower Earnings Limit, records a qualifying year for the State Pension
2. Employer pension contributions – deductible for Corporation Tax and not subject to Income Tax or NIC
3. Dividends from remaining profits – taxed at the dividend ordinary, upper or additional rate above the dividend allowance

This salary-dividend split can save a contractor earning £100,000 a substantial sum each year compared to taking the same amount as employment income.

Allowable expenses

As a contractor, you can claim expenses that are incurred wholly and exclusively for business purposes:

• Professional indemnity insurance and public liability insurance
• Accounting and legal fees
• Travel to temporary workplaces (but not if you work at the same client site for more than 24 months)
• Subsistence while travelling for business
• Training related to your current skills
• Equipment – laptop, phone, software subscriptions
• Home office costs – either flat rate or actual proportion of household expenses

The 24-month rule

You can claim travel and subsistence expenses to a temporary workplace. However, if you work at the same location for more than 24 months (or expect to), it becomes a permanent workplace and these expenses are no longer deductible.

If your contract is extended and you know you will be at the same site for over 24 months, you must stop claiming travel expenses from the point you know this.

VAT for contractors

The VAT registration threshold is £90,000. Many contractors exceed this, so VAT registration is common.

If all your clients are VAT-registered businesses, charging VAT is not a real cost to them (they reclaim it), so registration has no negative impact on your competitiveness. You can also reclaim input VAT on your business expenses.

The Flat Rate Scheme can simplify your VAT administration. You charge 20% VAT on your invoices but pay HMRC a lower flat rate percentage of your gross turnover. For IT contractors, the flat rate is typically 14.5%, meaning you keep the 5.5% difference.

However, since April 2017, “limited cost traders” (businesses whose goods cost less than 2% of turnover) pay a flat rate of 16.5%, which makes the scheme less attractive for many service-based contractors. Check whether the standard scheme or Flat Rate Scheme works better for your situation.

Record-keeping

Contractors must maintain the same records as any other business:

• All invoices issued to clients and agencies
• Receipts for all business expenses
• Bank statements for your business account
• Mileage logs if claiming vehicle expenses
• Contracts and IR35 status determinations

Keep records for at least 6 years from the end of the accounting period.

Key deadlines

Common contractor accounting mistakes

• Not setting money aside for tax – keep at least 25% of your gross income in a separate account
• Claiming expenses inside IR35 – if you are inside IR35, most expenses cannot be claimed against the deemed payment
• Ignoring the 24-month rule – continuing to claim travel expenses after exceeding the limit
• Not paying Corporation Tax on time – interest starts accruing from day one
• Mixing personal and business finances – use a dedicated business bank account
• Not reviewing your IR35 status when contracts change or renew

Getting set up

If you are new to contracting:

1. Incorporate your limited company at Companies House (£12 online)
2. Register for Corporation Tax with HMRC (within 3 months of starting to trade)
3. Open a business bank account
4. Register for VAT if your turnover will exceed £90,000
5. Get professional indemnity insurance
6. Choose accounting software to manage your bookkeeping, invoicing and VAT
7. Consider an accountant – a good contractor accountant more than pays for themselves in tax savings and compliance

Keep your company books clean between contracts. Start the free trial.