Contractor vs Employee: Tax Differences in the UK (2025-26)
The question of whether to work as an employee or as a contractor through a limited company is one of the most financially significant decisions a UK worker can make. The tax treatment differs substantially — and with IR35 applying to most public sector and large private sector engagements, the real-world difference is often smaller than it appears.
Employee: how PAYE works
As an employee, your employer deducts income tax and National Insurance from your pay before it reaches you. You pay employee NI (8% between £12,570 and £50,270, then 2% above that) and your employer pays employer NI on top (13.8% on earnings above £9,100 from April 2025). You receive employment protections: paid holiday, statutory sick pay, maternity/paternity pay, and pension auto-enrolment.
Limited company contractor: the tax structure
A limited company contractor typically:
- Pays themselves a low salary (often around £12,570 — the Personal Allowance threshold)
- Takes additional income as dividends from company profits
- Pays corporation tax on company profits (25% for most contractors in 2025-26; 19% for profits below £50,000)
- Pays dividend tax at 8.75% (Basic Rate), 33.75% (Higher Rate), or 39.35% (Additional Rate)
Example: £60,000 revenue — employee vs contractor
| Employee (PAYE) | Ltd Company Contractor | |
|---|---|---|
| Gross income | £60,000 | £60,000 |
| Corporation tax / employer NI | ~£7,000 (employer NI) | ~£4,750 (corp tax on dividends) |
| Income tax + employee NI | ~£15,232 | ~£2,286 (tax on dividends) |
| Approximate take-home | ~£44,768 | ~£48,500–£50,000 |
The contractor advantage narrows significantly when IR35 applies, as HMRC deems the contractor a "deemed employee" and taxes them on a PAYE basis — eliminating the dividend efficiency.
IR35: the critical variable
IR35 (off-payroll working rules) assess whether a contractor's engagement resembles employment. Key tests: substitution (can you send someone else?), control (who directs your work?), and mutuality of obligation (are you expected to accept all work offered?). In the public sector and large private firms, the client determines your IR35 status. Falling inside IR35 means PAYE tax applies to your contract income, removing most of the tax advantage of operating through a limited company.
Umbrella company vs limited company
Contractors who are inside IR35 or who prefer simplicity often work through an umbrella company. The umbrella employs you directly, handles all PAYE deductions, and passes the net pay to you. You lose the tax efficiency of a limited company but gain employment rights and no administrative burden. See our umbrella vs limited company guide for a full comparison.
Frequently asked questions
Is contracting through a limited company always more tax-efficient?
Not always — especially inside IR35. For outside-IR35 engagements below the Higher Rate threshold, a limited company can save several thousand pounds per year. Above £100,000, the personal tax efficiency gap narrows further.
Do contractors get holiday pay?
Limited company contractors outside IR35 do not receive statutory holiday pay — their day rate is expected to reflect that. Umbrella company workers retain statutory holiday rights.