What is IR35? - The Complete Guide
IR35 is a government legislation that was put in place to combat disguised employment and is something that as a contractor you must be aware of. Contractors who do not meet the definition of self-employment set out by HM Revenue and Customs (HMRC) and are seen as disguised employees, may find that they are caught by IR35, which will increase their tax and national insurance obligations.
What is IR35?
IR35 was put in place in April 2000 with the purpose of preventing contractors from receiving the benefits of permanent employment, such as job security, as well as the tax benefits that are available to limited company contractors.IR35 can seem confusing, mainly because whether you are caught by IR35 or not will depend on your individual situation, your working practices and the particular contract that you are carrying out. To help dispel some of the myths surrounding what can seem a bewildering topic, we have answered a few commonly asked questions regarding IR35.
To find out if your contract falls inside of IR35 use our IR35 Checker.
What would be classed as disguised employment?
An example of disguised employment would be if someone was to leave their permanent position on a Friday, only to return to the same position the following Monday, but on a contract basis working for their own limited company. In this case the contractor in question would be classed as inside or caught by IR35.
Through coming to the above arrangement the original employer would avoid paying Class 1 NIC at 13.8% and the (former) employee could arrange his payments between salary and dividends in order to minimise his tax and NI liabilities. The government introduced anti-avoidance legislation known as IR35 in April 2000 with the purpose of countering this problem.
What is inside and outside IR35?
Essentially, if your contract is giving you the same benefits as your client’s full-time employees then you may be inside IR35, or caught by IR35. Some examples of employee benefits are job security, sick pay, holiday entitlement and pension contributions.
A contractor who is outside of IR35 would be working as a separate entity and would not be receiving the benefits that permanent employees receive. As a limited company contractor who is working outside of IR35 you are entitled to increased tax planning opportunities, which compensate for the lack of job security and other benefits.
What factors constitute being inside or outside IR35?
The regulations that surround what constitutes being inside or outside IR35 are extremely complex and will depend on the contract in question and your working practices. It is important to remember that HMRC can review everything to establish if you are an employee or separate director of your own company. As a guide, we have put together a short list containing some of the factors, which could indicate whether your contract is inside or outside of IR35.
- Employee benefits – As a contractor you are not entitled to employee benefits such as training courses, holiday and sick pay, annual staff parties and pension contributions.
- Freedom – Are you free to work on your own or are you managed by your client? Contractors will generally work freely, whereas permanent employees are managed.
- Financial aspects – Workers that are permanently employed by a company will very rarely be taking a financial risk to be at work. However, being a separate entity means that contractors may have to purchase their own equipment, which depending on the length and rate of the contract in question could leave you out of pocket.
- Termination of contract – Typically permanent employees will have a notice period, but as a contractor your client will normally have the option to terminate the contract immediately if they so wish.
Can I still complete a contract if I am inside IR35?
If the contract that you would like to complete is inside of IR35 you are still able to complete the contract. However, you must declare that your contract is caught by IR35 and you will not be entitled to the same tax planning opportunities that contractors who are outside of IR35 would be.
There may be times you find yourself contracting inside of IR35, due to the nature and circumstances stipulated in your contract and working practices. Even though your contract maybe inside IR35 this doesn’t necessarily mean you should automatically think, I need to work through an umbrella company, as there are still many benefits of running your own limited company.
Should I use an umbrella company, instead of working inside IR35?
There are of course less benefits working through a limited company when operating inside of IR35, for example you can’t take dividend payments from your company. Though this is only fair as there are fewer burdens then if you were to be working outside of IR35, such as some contractors working inside IR35 still receive holiday pay, sick pay and attend staff training days.
Some of the benefits of working inside of IR35 over using an umbrella company include:
- The Flat Rate VAT scheme could increase your take home pay. For example if you were an IT contractor on a contract worth £100,000 you could increase your annual income by £2,054 by using the scheme. Unfortunately this scheme is only available to limited company directors and cannot be used by an umbrella company.
- Nixon Williams charges £95 plus VAT per month and takes care of all your personal and business taxation needs. Which is much less than may umbrella companies who can easily charge over £100 plus VAT a month, especially if your umbrella solution charges you a percentage based on your contract rate.
- HMRC will give you a 5% tax relief on your income which is intended to help with the administration costs of your company, such as accountancy fees, use of home, cost of seeking contracts, training coats and computer costs. If you choose to work through an umbrella company you would not be entitled to this 5% allowance and would need to pay 100% tax on your income.
- In addition to the 5% allowance for administration costs you could also claim for costs such as travel, pension contributions, direct training, umbrella/accountancy fees. However you can also claim for these through an umbrella company.
- Once your limited company is setup you can use the company for your next contract too, which could be outside of IR35.
Calculating your take home pay inside IR35
If working inside IR35 you would need to pay full income tax and National Insurance on your entire salary.
At the end of the tax year, you will need to work out your ‘deemed payment’. In a nutshell this is your turnover, minus your 5% allowance for running costs of the company.
If you have any allowable expenses such as travel, pension contributions, direct training and umbrella/accountancy fees, these would be deducted before turnover is calculated.
Once you have calculated your turnover minus 5%, you will need to take into account any salary or Employers NIC paid throughout the tax year.
If you’re left with a deemed payment figure higher than zero, you will need to pay further tax on this amount to HMRC. Don’t worry a good accountant should be able to help you work out these figures and ensure you’re working as tax efficiently as possible.
It’s always difficult for an accountant to give you an exact take home pay figure of, as there are so many factors to consider, that vary contractor to contractor such as:
- If you’re registered for the Flat Rate VAT Scheme.
- If you expenses the whole 5% tax relief for operating costs, if you choose not to, you’ll be liable for a small amount of corporation tax on the difference.
- If you have a pension and how much you pay into it
- Expenses that you have incurred to carry out your contract, such as travel costs.
Inside IR35 versus umbrella take home pay examples
Taking some of the above factors into consideration, the below table will show you roughly how much you could save working inside IR35 versus contracting through an umbrella company.
Take home pay inside IR35
Umbrella Take home pay
Difference in Take Home Pay
These examples assume the contractor:
- Has worked 44 weeks a year
- Has worked 44 hours a week
- Taken £10,392 of annual expenses (including pension contributions and any umbrella/accountancy fees)
- Taken a gross annual salary of £10,000 and if outside of IR35 taken dividend payments.
Who is responsible for ensuring that the contract is IR35 compliant?
As the director of your limited company it is you, not your end client that is responsible for ensuring that you are complying with all relevant legislation including IR35.
If you have any questions about IR35, becoming a contractor or would like an IR35 contract review then please get in touch with a member of our new business team, who will be happy to answer any questions that you may have. Our new business team can be contacted on 01253 362062 or firstname.lastname@example.org.
If you are new to contracting you may also find these pages useful:
- Limited company or umbrella company
- Advantages and disadvantages of a limited company
- Specialist Sectors
- A guide to contractor expenses
- Starting up as a contractor
- Moving from permanent to contracting
- Offshore tax avoidance schemes
- Contractor's guide to pensions