Contracting offers the freedom to work with different clients, take on new projects, and run your own business.
But contracting through your own limited company doesn’t necessarily mean you’re self-employed in HMRC’s eyes. Depending on your relationship with the client, your contract could fall inside IR35, which could result in a significantly higher tax bill.
So what’s the difference between inside and outside IR35, and how does it affect the way you’re paid?
Inside IR35 and outside IR35 explained
IR35 is tax legislation first introduced in 2000 which affects freelance contractors working through intermediaries, usually their own limited companies.
The original aim of the legislation was to prevent people from leaving permanent employment, setting up limited companies, and returning to work for their former employers to do essentially the same job while paying less tax.
This became known as ‘Friday to Monday’ contracting. However, IR35 applies much more widely than this particular arrangement.
A contract is inside IR35 if the relationship between the contractor and client would be one of employment for tax purposes if the intermediary were removed.
A contract is outside IR35 if the contractor is genuinely working in business on their own account.
The distinction isn’t always straightforward, and a contractor can have both inside and outside IR35 assignments.
How does being inside IR35 affect your tax?
If you’re working inside IR35 for a medium or large private sector client, or a public sector organisation, any Income Tax and National Insurance liabilities are normally deducted from your gross contract income before your company is paid.
The ‘deemed employer’, which is usually the recruitment agency or client paying your company, must also pay employer’s National Insurance (which comes out of your assignment rate).
This means if you’re inside IR35, you will pay approximately the same employment taxes as a traditional employee, but you don’t automatically qualify for employment benefits such as holiday pay or sick pay from the client.
This has always been seen as one of the most unfair consequences of the IR35 legislation.
When you’re operating outside IR35, your company is paid the full contract income without these deductions. Your company pays Corporation Tax on its taxable profits, and the directors can take money out of the business through salary and dividends.
You don’t pay National Insurance contributions on dividend income, which is one reason why limited company contracting has traditionally been more tax-efficient. However, following successive tax rises, the tax difference is far smaller than it was in 2000.
How do you know if you’re caught by IR35?
To work out whether a contract falls inside IR35, you must examine both the written contractual terms and the working practices (i.e. how the worker carries out their work).
The contract must reflect the reality of the role. If the contract says one thing but the contractor carries out their work differently in practice, the working practices may carry more weight.
Here are some key questions to consider when working before taking on an assignment.
Are you just replacing someone?
If you’re brought in to replace a permanent employee, particularly where you will be carrying out exactly the same duties, you should examine the terms of the contract carefully.
You won’t automatically fall within IR35 if you replace an employee, but if you’re subject to the same client control and have the same obligations as the person you’re replacing, this could indicate an employment relationship rather than self-employment.
Are you your own boss, or is the client in control?
Control is one of the most important factors in IR35 status.
A client will naturally want to agree on what work needs to be done and how and when it should be completed. However, how much control and direction do they have over how you work?
For example, if you’re expected to work fixed hours, stick to designated lunch breaks, and follow detailed instructions on how the work is carried out, this could indicate an employment relationship.
On the other hand, if you have freedom to decide how you complete a project (subject to agreed deadlines and requirements), this could help support an outside IR35 position.
Can you provide a substitute?
Another key IR35 status consideration is if your company can send a suitably qualified substitute to complete the work if you’re unable to do so.
If a client insists that you must personally undertake every aspect of an assignment, this may point towards employment.
If you have a genuine right to provide a substitute, this is a strong outside IR35 indicator, but for it to carry any weight, it must be genuine, not simply a boilerplate clause inserted into your contract.
What happens at the end of the contract?
Alongside control and substitution, another key status factor involves the mutuality of obligations between you and your client.
For example, is the client obliged to offer you further work once an assignment ends? Are you expected to accept any additional work if they offer it?
The answer may help establish whether the relationship resembles continuing employment or a contract to provide specific services.
There is no single definitive IR35 test. Alongside these well-known status factors, many others matter, including whether you take on any financial risk, provide your own equipment, and are allowed to have multiple clients at the same time.
Which arrangement gives you better take-home pay?
For many contractors, if your work is outside IR35, you will typically have higher take-home pay than an equivalent inside IR35 assignment.
But the difference depends on the contract rate, how much you earn, the expenses you incur, and how you extract money from your limited company.
There is also the question of how an inside IR35 rate is advertised.
If you’re offered £500 a day through an umbrella company, you won’t receive the full amount as gross salary. Employer’s National Insurance, any Apprenticeship Levy and the umbrella company’s fee will usually be deducted first, followed by PAYE and employee National Insurance.
Make sure you know exactly what the day rate includes before accepting a contract.
Who is responsible for determining your IR35 status?
Under the original 2000 IR35 legislation, contractors themselves (as company directors)were responsible for assessing their contracts and accounting for any additional tax due if caught by the new rules.
This changed in April 2017 for public sector contracts and in April 2021 for medium and large private sector clients.
These organisations are now responsible for determining whether an engagement falls inside or outside IR35 and for deducting any employment tax from the contractor’s gross earnings.
They must always provide a Status Determination Statement (SDS) explaining how they came to their decision.
However, if you work for a small private sector client, you (the contractor) are normally responsible for assessing your own IR35 status.
You can read more in our comprehensive guide to who decides your IR35 status.
Can you have inside and outside IR35 contracts at the same time?
Yes, the IR35 rules apply on a contract-by-contract basis, not to a person or to the contractor’s limited company.
You might be working inside IR35 for one client while carrying out a completely separate consultancy project for another client on an outside IR35 basis.
Because income from each arrangement is taxed differently, talk to your accountant if you have any questions.
Should you close your limited company if you’re inside IR35?
No, not necessarily, especially if you’re likely to take on outside IR35 again in the future.
However, if you expect to work solely via an umbrella company for the foreseeable future, there may be less incentive to keep paying to maintain a limited company you no longer use.
Depending on your circumstances, making the company dormant for a period of time might be the right option.
At BI Accountancy, we help limited company contractors manage their accounts and tax affairs, whether they work inside IR35, outside IR35, or a mix of both. If you’re unsure how IR35 affects your business, get in touch to see how we can help.
