Contractor, sole trader or employee: what`s the difference?
Taking the decision to go self-employed can be a difficult one. After all, there are so many variables that you need to weigh up. Flexibility on one side, but a secure salary on the other. Paid annual leave and sick pay in one camp, but the freedom to take whatever days off you like in the other. And they’re just a few of the simplest differences.
Of course, it also doesn’t help that there’s more than one way to be self-employed. In short, it’s an entire minefield that you need to navigate to decide on your future career path.
To help with your decision making, we’ve laid out the differences between being an employee, a sole trader, and a contractor, as well as the pros and cons of each, and some other things you would need to consider as a self-employed person. So, read on for all the info you need to help you make an informed choice.
This article is for information purposes only and should not be seen as financial advice.
What is an employee?
Hopefully, you’re already pretty familiar with what an employee is but, in short, it’s anyone who is employed in a role on a permanent basis (although it is also possible to be a temporary employee). An employee receives their wages and benefits from their employer (usually monthly but sometimes weekly) and have PAYE tax and National Insurance Contributions (NICs) deducted at source.
Employees are also protected by employment rights and, as such, get paid annual leave, sick pay, guaranteed hours and redundancy protection.
Pros of being an employee
- Secure, guaranteed salary
- Rights such as annual leave, sick pay and redundancy protection
- Perks such as company cars, gym memberships etc., depending on the employer
- Cons of being an employee
- Any flexibility or time off is at the discretion of your employer
- Lack of control over your work
- No tax relief available to you
What is a limited company contractor?
A contractor operates as the director of their own company. They work with clients on fixed-term contracts to provide services.
As a limited company contractor, you and your business remain separate from one another, so you personally are not liable for any losses. It’s a very tax-efficient way of working, as some contractors draw a small salary from their company and pay the rest to themselves in dividends, meaning that they pay a lower rate of tax.
However, you also need to consider IR35 legislation (more on that later).
Pros of being a contractor
- You are not personally liable for any losses
- It’s tax-efficient compared to being an employee or sole trader
- You tend to appear more credible than sole traders as you are registered with Companies House
- You have much more flexibility than employees
Cons of being a contractor
- Your income is not guaranteed and you have no employee rights
- It’s more complicated than being a sole trader as there is more paperwork
- Your business accounts are public through Companies House
- You need to deal with IR35, one way or another.
What is a sole trader?
Being a sole trader is generally considered to be the simplest way of being self-employed. Rather than having a limited company, the individual themselves is the business. This, however, does mean that you are personally liable for any losses. It can also be less tax-efficient than operating as a limited company.
However, you have the same levels of flexibility and you don’t have to consider IR35 legislation.
Pros of being a sole trader
- Easy to set up
- Comparatively little admin
- You keep all business profits after tax
- You have complete control and flexibility
- No need to consider IR35 rules
Cons of being a sole trader
- You are individually liable for any loss
- Less tax-efficiency than limited company contractors
- Often appears less credible to potential clients
What other things do the self-employed need to consider?
Anyone setting up as a limited company contractor needs to consider IR35 and how it affects them. These are the rules put in place to prevent people acting as “disguised employees” – effectively being employees while enjoying the tax relief that comes with being a contractor.
As a contractor, it needs to be decided if you are ‘inside’ IR35 – i.e. the rules apply to you – or ‘outside’ IR35 – i.e. the rules don’t apply to you.
If you are inside IR35 for a contract, it basically means that you will be taxed at source using PAYE and will pay the same tax and NICs as employees. If you are outside IR35, then you are liable for your own tax and NIC payments through self-assessment.
In general, your client will decide if you are inside or outside IR35, and your fee payer will hold the tax liability, but there are exceptions, for instance, if your client is a small business. You can find out more about IR35, including all of the exceptions, on our Knowledge Hub.
Managing your own accounts
If you’re self-employed you need to manage your accounts. Of course, there are options out there to help you, such as accountants, or accounting software, but you do still need to keep track of your incomings and outgoings and ensure you’re filing all of your invoices, receipts and other paperwork.
It’s vital that you keep on top of this so you’ll need to be organised.
If you’re self-employed, you’ll also be responsible for your own contractor insurance (this is true whether you’re a contractor or sole trader).
At the very least you’ll need professional indemnity, public liability and employers’ liability as these are required in most contracts. But the main reason to get the correct insurance is that it protects you financially should the worst happen. All it takes is a mistake and you could find yourself having to pay out to compensate a client, but if you have the right insurance, you’ll be covered.