An IT freelancer’s guide to working through an umbrella company

Changes in tax legislation, notably the introduction of the off-payroll working rules, have seen more independent contractors working through umbrella companies.

However, navigating the world of ‘brollies’ can be daunting and requires due diligence.

Here, exclusively for Free-Work, I want to empower contractors considering or currently working with umbrellas by providing advice on umbrella company structure, pay, rights and expenses, writes Crawford Temple, CEO of Professional Passport, the UK’s leading compliance assessor for payment intermediaries.

I will also pinpoint some critical red flags for IT freelancers to be aware of before selecting an umbrella partner.

What is an umbrella company?

An umbrella company acts as the direct employer for contractors working temporary assignments.

Contractors are paid as employees through PAYE, with continuous contracting across assignments.

Most umbrella companies comply with employment and tax law, but without specific regulations for umbrella companies, contractors must vet these potential partners carefully.

Why have umbrella companies become more popular?

Previously, and before the OPW rules of 06.04.17 in the public sector, and 06.04.21 in the private sector, recruitment agencies in tech and other sectors often paid contractors directly.

But since the off-payroll working (OPW) rules took effect, agencies now often handle ‘inside IR35’ contractors either on the agency’s payroll or through an umbrella.

Many agencies now rely entirely on umbrellas to handle payroll, pensions, and all other ‘employer obligations’ that the agency cannot take on itself.

Typically, the agency provides the umbrella an ‘uplifted rate’ to cover employment costs rather than your direct ‘PAYE rate.’

And this uplifted rate includes the umbrella’s fees as well.

Trustworthy, reputable agencies tend to confirm to the contractor both the PAYE rate you would earn through direct payment -- and the actual uplifted rate supplied to the umbrella for your employment.

What are the advantages of this agency-umbrella chain set-up for contractors?

As umbrella employees, contractors gain typical employee rights like minimum wage, paid holiday, pension auto-enrolment, sick pay eligibility, and maternity/paternity protections.

Umbrella employment also provides continuity between assignments, whereby pay and rights might otherwise be interrupted. You (as the employee / contractor) gain the dual benefit of PAYE tax obligations together with continuous contracting flexibility.

How is the rate of pay calculated if you use an umbrella company?

Understanding umbrella pay rates is key, as the rate the umbrella receives differs substantially from your take-home pay.

Trustworthy, reputable umbrellas can provide you with ‘pay comparison’ documentation to demonstrate how your net pay matches what you would receive under direct agency PAYE, once all deductions and contributions have been accounted for.

Should contractor take-home pay between umbrella companies vary?

As all umbrellas operate under the same tax rules (set by HMRC), take-home pay for you, the employee / contractor, should not vary more than a few pence between compliant firms.

So be on guard because if one umbrella promises significantly higher net pay than this industry standard, they are likely concealing non-compliance that will very likely incur (you) future tax debts.

Contracting via an umbrella? Get a personal tax account with HMRC

One way to monitor your earnings is by signing up for a Personal Tax Account with HMRC: https://www.gov.uk/personal-tax-account.

With a Personal Tax Account, contractors can check that the earnings that are reported on their payslips are the same as those reported to HMRC, as the information is regularly updated following Real Time Information (RTI) submissions.

Freshly published guidance from the government dictates that agencies should be clear about pay rates when they advertise a job.  This guidance is welcome, because when an agency passes a worker to an umbrella company, it must make sure that it hands over the correct amount of money to the umbrella company.  

Where does an umbrella contractor’s pay come from?

And this amount is the total sum received from the end-client as payment for the work. It includes the gross pay rate advertised to the worker (‘the agency rate’) plus all of the costs of employment that the umbrella company will now have (for example holiday pay), and the umbrella’s margin. These things together make up what’s called the ‘assignment rate’. This money becomes the umbrella company’s income, from which it will then pay you your wage.

As a contractor, be sure to understand what rate your agency is quoting you to work through an umbrella company – is it the ‘agency rate’ or is it the uplifted ‘assignment rate’? It should be the assignment rate.

How is holiday pay calculated when using an umbrella company?

Most brollies provide 28 days of paid holiday as part of contractual employment terms.

Holiday pay funds accrue at 12.07% of your gross taxable pay, held by the umbrella to pay out when you take leave or are between assignments.

If you work irregular hours, under a typical umbrella company contract, it used to be the case that your holiday entitlement would probably be calculated as a percentage of hours/earnings. 28 days paid leave (or 5.6 weeks) is equivalent to 12.07%, assuming a working year of 46.4 weeks (i.e. 52 weeks minus the 5.6 weeks). Some umbrella companies have an education-specific percentage of 14.36%, as there is a shorter (39-week) working year.

What expenses can be claimed if you work through an umbrella company?

Expenses can be claimed against general earnings, like mileage to temporary work sites, or as separately reimbursed income if the agency repays specific costs.

Reimbursed expenses require detailed documentation for the umbrella to verify tax compliance.

We recommend you discuss expenses policies upfront to ensure the umbrella can accommodate your needs. Expenses are generally a complex process and where there is an expectation to claim either mileage or be reimbursed expenses from an agency, then this should be fully discussed with the umbrella to ensure expectations align.

Lastly, those promised red flags! Be careful when selecting an umbrella company

Since the new OPW rules came into effect, a proliferation of tax avoidance schemes has arrived on the scene masquerading as ‘umbrellas companies’ and offering higher take-home pay.

If you are tempted to engage with one of these disguised remuneration schemes, you could face significant future tax bills once HMRC discovers the arrangement you have elected to use.

Be warned and be alert -- take-home pay should not be one of the criteria used to select an umbrella company, as compliant umbrellas should all be offering within a few pence of each other.

To avoid getting taken in by a scheme, remember the old, HMRC-endorsed adage, ‘If it sounds too good to be true, then it probably is.’ Or as we often tell contractors, ‘If it sounds too good to be true, then alarm bells should ring!’

Not sure? Don’t be afraid to ask

Very finally, transparency is key. As a contractor working through an umbrella, it is important to be diligent and informed about how your agency and umbrella work with you. Pose them questions and do not be afraid to ask about or challenge anything you do not understand.