There is a considerable difference in the take-home pay between a limited company worker whose contracts fall outside IR35 and another who is caught by the rules.
In practice, the tax treatment of contractors can vary significantly depending on whether a contract is deemed to fall inside or outside IR35.
What is IR35?
In a nutshell, IR35 (the Intermediaries Legislation) was created in 2000 to clamp down on ‘disguised employment’; to prevent contractors and others who would typically be viewed as ’employed’ by HMRC from being taxed as if they were ‘self-employed’.
For example, a contractor might work for a large consultancy as a permanent employee one day, only to return the following day as a contractor through a limited company.
The contractor would benefit from the tax advantages of working through a company, despite working in exactly the same way as before. According to HMRC, he would be deemed a ‘disguised employee’.
How the IR35 rules are applied
New Off-Payroll rules were introduced in the public sector in 2017 and extended to medium and large private sector organisations in 2021. These reforms made clients responsible for determining a contractor’s employment status in many cases.
However, where the client qualifies as a small company, the original IR35 rules (known as Chapter 8) still apply, and the contractor’s company remains responsible for assessing IR35 status.
What determines whether a contract falls inside or outside IR35?
Whether a contract falls inside or outside IR35 depends on the contractor’s employment status. HMRC and the courts look at the overall working relationship between the contractor and the client.
Three factors are usually considered particularly important:
- Control – how much control the client has over how, when and where the work is carried out.
- Substitution – whether the contractor can send a substitute to perform the work instead.
- Mutuality of obligation – whether the client is obliged to offer work and the contractor is obliged to accept it.
Other factors may also be considered, including financial risk, whether the contractor provides their own equipment, and whether they appear to be operating as a genuine business.
IR35 status is determined by actual working practices, not just the wording of the written contract.
Outside IR35
If you are a professional contractor who works via your own limited company and your contracts fall outside IR35, you will usually draw down a small salary from your company.
For guidance on typical salary levels, see our article on contractor director salaries.
You can then draw down the company’s retained profits as company dividends. There are no National Insurance contributions to pay on dividends, although dividend tax still applies.
In recent years, the tax benefits of working via your own company have shrunk significantly. Dividend tax rates increased in April 2016, and higher Corporation Tax rates introduced from April 2023 have increased the tax burden for many company owners.
There are still several tax planning options open to company owners which are not available to employees; such as the ability to divide company shares with a spouse to reduce higher rate tax liabilities, and the opportunity to delay drawing down funds until a future tax year.
It is worth bearing in mind that company owners do not have the perks associated with standard employment. The (often modest) tax advantage they enjoy will typically cover costs such as insurance, accountancy fees, training, and other business expenses.
Inside IR35
On the other hand, if your contracts fall within IR35, you will receive income as a ‘deemed payment‘. This means most of the income received by your company is treated as employment income, and you must pay income tax and National Insurance contributions on the relevant earnings.
Where the contractor is responsible for determining IR35 status (under the original Chapter 8 rules), a 5% expense allowance is available to cover the general costs of running a limited company.
However, this allowance is not available where the off-payroll rules apply, for example when working for a public sector body or a medium or large private sector organisation.
Certain expenses, such as pension contributions and some business insurance costs, may still be allowable.
In practice, contractors caught by IR35 may either continue working through their own limited company or move to an umbrella company arrangement, where they are paid through PAYE.
All limited company contractors must still calculate their Corporation Tax and VAT liabilities in the normal way, regardless of whether they are caught by IR35.
What is the financial impact in real terms?
There is often a noticeable difference in the take-home pay of contractors working inside and outside IR35.
However, the gap has reduced in recent years. Changes to dividend tax rates, reductions in the dividend allowance and higher Corporation Tax rates have all narrowed the tax advantage of operating through a limited company.
The exact financial impact can also depend on how a contractor is engaged. A contractor working inside IR35 through their own limited company may have a different take-home result compared to someone working through an umbrella company operating PAYE payroll.
Because the outcome depends on a number of variables — including day rate, pension contributions, working weeks and expenses – the best way to understand the impact is to use an IR35 calculator.
For obvious reasons, you should always seek professional advice before signing a contract, and ensure that both your written contracts and your working practices demonstrate that you fall outside the IR35 rules where appropriate.
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