Complete Guide for UK Contractors
All tax calculations in this guide use 2025/26 tax year rates and thresholds.
Working as a contractor in the UK offers flexibility and potentially higher earnings than permanent employment, but it comes with complexity. You need to understand business structures, IR35 rules, tax planning, and how to maximise your take-home pay whilst staying compliant with HMRC.
This guide covers everything contractors need to know: from choosing between limited company, umbrella, and sole trader, to optimising your salary and dividends, claiming expenses, and navigating IR35.
The Three Contractor Structures
| Structure | Tax Efficiency | Admin Burden | IR35 Risk | Best For |
|---|---|---|---|---|
| Limited Company | High (if outside IR35) | Medium-High | Must assess each contract | Established contractors, multiple clients |
| Umbrella Company | Low (PAYE employee) | Low | None (always inside IR35) | New contractors, single client, IR35 caught contracts |
| Sole Trader | Medium | Low-Medium | N/A (self-employed) | Very small projects, part-time contracting |
Limited Company: The Standard Contractor Structure
How It Works
You set up a private limited company. You're both the director and (usually) sole shareholder. The company invoices your clients, pays corporation tax on profits, and you take money out as a combination of salary and dividends.
Typical Income Structure
Most contractors use this structure:
- Small salary: £9,100-£12,570/year (up to personal allowance, avoids income tax)
- Dividends: Remaining profits after corporation tax
- Pension contributions: Company pays directly into SIPP (reduces corporation tax)
- Expenses: Business costs paid by company (reduces corporation tax)
| Item | Amount | Notes |
|---|---|---|
| Company Revenue | £80,000 | What you invoice clients |
| Less: Expenses | -£5,000 | Office, software, travel, etc. |
| Less: Salary | -£12,570 | Your director's salary (personal allowance) |
| Less: Employer NI | -£1,136 | Secondary threshold crossed on £12,570 salary |
| Less: Company pension | -£10,000 | Paid directly to your SIPP |
| Taxable Profit | £51,295 | |
| Less: Corporation Tax (with marginal relief) | -£9,843 | Calculated via 25% main rate minus marginal relief |
| Available for Dividends | £41,451 | |
| Less: Dividend Tax | -£4,396 | £500 allowance + basic/higher bands |
| Net Take-Home | £49,625 | Salary + dividends after all tax |
| In Pension | £10,000 |
Total benefit: £59,625 (take-home after tax plus £10k pension)
Assumes no associated companies. If you have associated companies, the small profits threshold falls and the effective corporation tax rate on £52k profit rises further (~22–23%).
Since April 2023, profits up to £50,000 are taxed at 19%, £250,000+ at 25%, and the band in between gets marginal relief. The example above assumes profits in the 19% band; if your company keeps more profit, expect an effective corporation tax somewhere between 19% and 25%. Plan dividend timing and pension contributions with these bands in mind.
Advantages
- Most tax-efficient if outside IR35
- Company pension contributions avoid income tax and NI entirely
- Claim business expenses
- Flexibility in timing dividends
- Professional credibility
- Limited liability protection
Disadvantages
- Admin overhead (accounts, Companies House filings, tax returns)
- Accountant fees (£1,000-£2,000/year typically)
- Must assess IR35 for each contract
- Dividends don't count as "earnings" for mortgages (though many lenders now accept them)
Understanding IR35 (Off-Payroll Working Rules)
IR35 determines whether you're truly self-employed or a "disguised employee." If HMRC considers you caught by IR35, you must pay tax as if you were an employee. This losese you most of the tax advantages of a limited company.
The Three Tests
HMRC looks at three main factors:
- Supervision, Direction, and Control: Does the client tell you how, when, and where to work? (Bad for outside IR35)
- Substitution: Can you send someone else to do the work? (Good for outside IR35)
- Mutuality of Obligation: Must the client provide work? Must you accept it? (Obligation = bad for outside IR35)
Who Decides?
- Private sector: The client decides and issues a Status Determination Statement (SDS)
- Public sector: The client decides (since 2017 reforms)
- Small companies: You decide (if client is "small" under Companies Act)
If caught by IR35, you must operate "deemed employment." The company pays PAYE and NI on all income above your salary, losing the dividend tax advantage. Many contractors earning £80k outside IR35 (taking home ~£58k) would only take home ~£54k inside IR35, i.e. a £4k difference.
Umbrella Companies: The Simple Option
How They Work
You become an employee of the umbrella company. The client pays the umbrella, the umbrella pays you a salary via PAYE. You're always "inside IR35" but you have no admin, the umbrella handles everything.
Avoid umbrellas offering "loan" or "advance" payments, offshore schemes, or take-home promises over ~70% after fees— these are often disguised remuneration and can lead to HMRC bills. Use FCSA-accredited umbrellas or ones recommended by your agency, and check whether holiday pay is transparently shown on your payslip.
Take-Home Comparison
| Structure | Day Rate | Annual Revenue | Take-Home | Effective Rate |
|---|---|---|---|---|
| Limited (outside IR35) | £400 | £80,000 | £54,495 | 68.1% |
| Limited (inside IR35) | £400 | £80,000 | £54,200 | 67.8% |
| Umbrella | £400 | £80,000 | £52,500 | 65.6% |
Note: Outside-IR35 take-home assumes £5k expenses, £12,570 salary, no pension contributions. Umbrella take-home is slightly lower than inside IR35 limited company due to umbrella fees (£100-£150/month) and employer NI (which the umbrella deducts from your gross before calculating your salary).
When to Use Umbrella
- Your contract is inside IR35
- You're new to contracting and want to try it first
- You have a single client and don't want admin overhead
- You're contracting part-time alongside permanent employment
Sole Trader: The Simplest Structure
How It Works
You register as self-employed with HMRC. You invoice clients directly, pay income tax and NI on your profits via self-assessment. No company, no dividends, just you as a self-employed individual.
Advantages
- Simplest to set up (just register with HMRC)
- Lower accountancy fees or DIY accounting
- Claim business expenses
- No Companies House filings
Disadvantages
- Less tax-efficient than limited company (pay income tax and NI on all profits)
- No dividend option
- Unlimited liability (your personal assets at risk)
- Less professional perception for some clients
When to Use Sole Trader
- Very small contracts (under £30k/year)
- Part-time contracting
- You want maximum simplicity
Optimising Salary vs Dividends
The Optimal Salary
Most contractors pay themselves a salary between £9,100 and £12,570 (the personal allowance). This avoids income tax whilst building State Pension entitlement.
| Salary Option | Income Tax | Employee NI | Employer NI | State Pension? | Best For |
|---|---|---|---|---|---|
| £9,100 | £0 | £0 | £0 | ✅ Yes | Maximum tax efficiency |
| £12,570 | £0 | £0 | £0 | ✅ Yes | Standard choice |
| £50,270 | £7,540 | £3,844 | £5,196 | ✅ Yes | Mortgage applications (higher "salary") |
Note: Paying more salary only makes sense if you need to show higher income for a mortgage. Otherwise, dividends are more tax-efficient.
Dividend Tax Rates (2024/25)
| Tax Band | Income Range | Dividend Tax Rate | Effective Rate (after 19% corp tax) |
|---|---|---|---|
| Dividend Allowance | First £500 | 0% | 19% (just corp tax) |
| Basic Rate | £500 - £50,270 | 8.75% | 26.1% |
| Higher Rate | £50,270 - £125,140 | 33.75% | 46.6% |
| Additional Rate | Over £125,140 | 39.35% | 51.0% |
Combined rate includes both corporation tax (paid by company) and dividend tax (paid by you). Even at higher rate, dividends are more efficient than salary (which faces 40% income tax + 12% employee NI + 13.8% employer NI).
Claiming Business Expenses
Limited companies and sole traders can claim legitimate business expenses, reducing taxable profit. The key test: is it "wholly and exclusively" for business purposes?
Common Allowable Expenses
- Office costs: Dedicated home office (simplified £6/week or actual costs), equipment, furniture
- Travel: Client site visits, business meetings (not ordinary commuting), accommodation
- Professional fees: Accountant, professional indemnity insurance, professional subscriptions
- Technology: Laptop, monitor, software subscriptions, mobile phone (business use)
- Training: Courses to maintain/improve skills for current role
- Marketing: Website, business cards, advertising
- Legal and financial: Contract reviews, bank charges
HMRC is strict about certain expenses:
- Ordinary commuting: Regular travel from home to a permanent workplace
- Clothing: Unless it's protective or branded workwear
- Subsistence: Meals unless overnight or genuinely exceptional circumstances
- Personal use: Any expense with personal benefit (e.g., gym membership, Netflix)
VAT Registration and Flat Rate Scheme
When to Register
- Mandatory: When revenue exceeds £90,000 in any 12-month period
- Voluntary: You can register below this threshold
Should You Register Voluntarily?
Depends on your clients:
- B2B clients (VAT-registered): They can reclaim your VAT, so it doesn't cost them extra. Register and use flat rate scheme for profit
- Consumers or non-VAT clients: VAT makes you 20% more expensive. Don't register unless required
VAT Flat Rate Scheme
Most contractors use the Flat Rate Scheme. Instead of tracking VAT in and out, you pay HMRC a fixed percentage of your gross turnover. For IT contractors: 14.5% (or 16.5% if you're a "limited cost trader").
Invoice to client: £10,000 + £2,000 VAT = £12,000
Pay HMRC (16.5% flat rate): £12,000 × 16.5% = £1,980
You keep: £12,000 - £1,980 = £10,020
Effective benefit: £20 extra compared to standard VAT
The benefit is small but worthwhile. The main advantage is reduced admin, no tracking VAT on every expense.
See our VAT Flat Rate glossary entry for full details.
Tax Planning Strategies for Contractors
The November 2025 Budget announced plans to cap National Insurance savings on salary sacrifice pension contributions, with changes scheduled for April 2028. Income tax relief remains, but employer/employee NI savings may be limited above a to-be-confirmed threshold. If you rely on heavy salary sacrifice (e.g., inside-IR35 or umbrella), plan cash flow and contribution timing accordingly and watch provider updates during 2026/27 consultations.
1. Company Pension Contributions
Your company can pay directly into your SIPP. This:
- Reduces corporation tax (19% saving)
- Avoids dividend tax entirely
- Doesn't count as income for childcare benefit limits
- Builds retirement savings
Take £10,000 as dividend:
- Corporation tax: £1,900
- Dividend tax (higher rate): £2,700
- Total tax: £4,600
- Net to you: £5,400
Company pays £10,000 to pension:
- Corporation tax saved: £1,900
- Dividend tax: £0
- In pension: £10,000
- Company cost: £8,100
Result: £10,000 in pension vs £5,400 in hand, almost double the value
2. Timing Dividends
You control when to declare dividends. Strategic timing helps with:
- Spreading dividends across tax years to use personal allowances
- Staying under £100k for childcare benefits (declare dividend in April instead of March)
- Avoiding higher-rate band if you have other income in some years
- Timing large dividends for lower-income years (e.g., maternity/paternity leave)
3. Spouse/Partner as Shareholder
If your spouse/partner doesn't work or is a lower-rate taxpayer, you can make them a shareholder. Dividends split between you both can save significant tax.
HMRC's "settlements legislation" (Arctic Systems case) means this only works if your spouse has genuine involvement in the business. Simply giving them shares whilst they do nothing can be challenged. Always get professional advice.
4. Retaining Profits in Company
You don't have to take all profits as dividends. Leaving money in the company:
- Defers dividend tax until you need the money
- Builds a "buffer" for quiet periods
- Can be useful for large purchases (company car, equipment)
- Reduces your "adjusted net income" for that year
But watch out: retained profits over £50,000 face higher corporation tax (26.25% instead of 19%).
Common Contractor Mistakes
Keep business and personal finances completely separate. Use a dedicated business bank account. Never pay personal expenses from the company account (except salary/dividends properly declared).
Keep all invoices, receipts, bank statements, and contracts for at least 6 years. HMRC can investigate that far back. Digital is fine, take photos of receipts and use accounting software.
"I'll deal with it if HMRC asks" is not a strategy. If caught by IR35 retrospectively, you face huge tax bills, interest, and penalties. Get contracts reviewed and keep evidence of your working practices.
You can only pay dividends from distributable reserves (profit after tax). Paying "illegal dividends" from unprofitable periods creates personal liability. Work with your accountant to know what's available.
How Our Calculator Helps
Our contractor calculator shows you:
- Optimal split between salary and dividends for your revenue
- How much corporation tax and dividend tax you'll pay
- Impact of pension contributions on take-home and taxes
- Whether you're approaching the £100k childcare cliff edge
- Comparison between inside and outside IR35 structures
- How expenses reduce your tax bill
Key Takeaways
- Limited company is most tax-efficient if outside IR35
- Corporation tax bands now 19% (under £50k) to 25% (over £250k) with marginal relief in between
- Optimal salary is usually £9,100-£12,570 (personal allowance)
- Take remaining profits as dividends (more tax-efficient than salary)
- Company pension contributions avoid all income tax and NI
- IR35 determines whether you can use tax-efficient structure, get contracts reviewed
- Umbrella companies are simple but least tax-efficient; avoid non-compliant "loan" schemes
- Budget 2025: salary sacrifice NI savings expected to be capped from April 2028—monitor scheme updates
- VAT Flat Rate Scheme simplifies admin for most contractors
- Keep meticulous records, separate business and personal finances
- Time dividends strategically to minimise tax and preserve childcare benefits
- Get a good accountant, they'll save you more than their fee