What Is IR35 and Why Does It Matter?

IR35 is the shorthand name for the off-payroll working rules that HMRC uses to decide whether a contractor working through their own limited company should pay tax and National Insurance as if they were an employee. The full name is the Intermediaries Legislation, and it has been in force since April 2000. But it is only in the last few years that it has become the defining issue for UK contractors and the businesses that hire them.

If you are a contractor, IR35 determines whether you can pay yourself through dividends and retain the tax advantages of running a limited company, or whether you must be taxed on a "deemed employment" basis where your limited company pays employer NI and deducts PAYE and employee NI from your income. If you are a business that hires contractors, IR35 determines whether you or the contractor is responsible for making that determination.

This guide is for UK business owners, contractors, freelancers, sole traders considering incorporation, and small businesses that engage contractors. It covers the rules as they stand for the 2025/26 tax year, including the changes that took effect from April 2021 for medium and large businesses, and the ongoing reforms to the off-payroll working rules. We are ICAEW qualified accountants who work with contractors and businesses across the UK, from London's Shoreditch to Manchester's Northern Quarter, and we have seen the full range of IR35 scenarios.

IR35 explained properly means understanding three things: what triggers it, how to assess your status, and what happens when HMRC challenges you. Let us start with the fundamentals.

How IR35 Works: The Core Principle

The Intermediaries Legislation Explained

IR35 applies when a contractor provides their services through an intermediary, typically their own limited company, but would be classed as an employee if they were engaged directly by the client. The legislation treats the limited company as a "personal service company" (PSC) and asks: if the contract between the client and the contractor were direct, would the relationship be one of employment?

If the answer is yes, IR35 applies. The contractor's company must then pay tax and NI on the "deemed employment payment", the income earned from that contract, minus certain allowable expenses, as if the contractor were an employee of the client.

If the answer is no, the contractor can continue to pay themselves through dividends and benefit from the lower tax rates available to company owners. This is what contractors call being "outside IR35."

Inside IR35 vs Outside IR35

The distinction between inside and outside IR35 is the single most important concept for contractors. It affects your take-home pay, your tax planning, and your entire business model.

Inside IR35: Your limited company receives the contract income, but must deduct PAYE and employee NI before paying you. Your company also pays employer NI. You cannot take dividends from that income. Your effective tax rate is significantly higher, often leaving you with around 60-70% of the contract value after all taxes, compared to 75-85% outside IR35.

Outside IR35: Your limited company receives the contract income gross. You can pay yourself a small salary (typically up to the NI threshold) and take the rest as dividends, paying corporation tax at 19% or 25% on the profit and dividend tax at 8.75%, 33.75% or 39.35% depending on your total income. You control your own tax planning.

The Three Key Tests HMRC Uses

HMRC does not have a single checklist. They look at the overall picture, but three factors dominate every IR35 case:

  • Substitution: Can you send a substitute to do the work? A genuine, unfettered right of substitution points strongly to being outside IR35. If the contract says you must do the work personally, that points to employment.
  • Control: Does the client control what you do, when you do it, and how you do it? A contractor who sets their own hours, uses their own methods, and is not managed day-to-day is more likely to be outside IR35.
  • Mutuality of Obligation (MOO): Is the client obliged to offer work, and are you obliged to accept it? Employment requires ongoing MOO. A fixed-term project with no ongoing commitment points to being outside IR35.

These are not the only factors. Financial risk, equipment provision, integration into the client's business, and the existence of a personal service are all relevant. But substitution, control, and MOO are the three pillars that every IR35 assessment rests on.

Factor Points to Employment (Inside IR35) Points to Self-Employment (Outside IR35)
Substitution No right of substitution. Client wants you personally. Genuine right to send a substitute. You are not required to do the work personally.
Control Client tells you when, where and how to work. You are managed day-to-day. You decide your working pattern. Client sets outcomes, not methods.
Mutuality of Obligation Client must offer work; you must accept. Ongoing relationship. Fixed project or deliverable. No obligation beyond the current contract.
Financial Risk No financial risk. You are paid for time, not results. You bear financial risk. You invoice for outcomes, not hours.
Equipment Client provides all equipment, including laptop and software. You provide your own equipment and tools.
Integration You work as part of the client's team. You attend staff meetings. You work separately. You are not part of the client's hierarchy.

Who Is Responsible for Determining IR35 Status?

Public Sector: The 2017 Changes

From April 2017, public sector clients became responsible for determining the IR35 status of contractors engaged through their own limited company. This was the first major reform to the off-payroll working rules. Public sector bodies, including government departments, NHS trusts, local authorities, and universities, must issue a Status Determination Statement (SDS) to the contractor and the fee-payer (usually the recruitment agency).

If the public sector client determines the contract is inside IR35, the fee-payer must deduct PAYE and NI from the contractor's income. The contractor cannot challenge the determination themselves, though there is a client-led disagreement process.

Medium and Large Private Sector: The 2021 Reforms

From 6 April 2021, the off-payroll working rules were extended to medium and large private sector clients. This was the change that sent shockwaves through the UK contracting community. Many contractors saw their outside IR35 contracts reclassified as inside IR35 overnight. Some took rate increases to compensate. Others moved to umbrella companies or left contracting entirely.

A medium or large client is one that meets two of the following three criteria: annual turnover above £10.2 million, balance sheet total above £5.1 million, or more than 50 employees. If the client is small (turnover below £10.2 million, balance sheet below £5.1 million, and fewer than 50 employees), the contractor remains responsible for their own IR35 determination, just as before 2021.

Small Clients: The Contractor Remains Responsible

If you are a contractor working for a small client, you are still responsible for determining your own IR35 status. This is the pre-2021 model. You must assess whether your contract and working practices fall inside or outside IR35, and if inside, you must operate the deemed employment payment through your limited company's payroll.

Many contractors prefer working for small clients precisely because they retain control over their IR35 status. But the risk is also yours. If HMRC challenges you and decides you were inside IR35, you face the tax bill, interest, and penalties, not the client.

How to Assess Whether a Contract Is Inside or Outside IR35

The CEST Tool: HMRC's Online Assessment

HMRC provides the Check Employment Status for Tax (CEST) tool, an online questionnaire that asks about substitution, control, MOO, and other factors. It then gives a determination of inside or outside IR35. The tool is free and anonymous.

CEST has its critics. It can give inconsistent results, and it does not handle every scenario well. But HMRC has said they will stand by a CEST determination if the information provided is accurate. For many contractors and businesses, CEST is the starting point, not the final word.

If CEST says "outside IR35" and you have answered honestly, HMRC will generally not challenge that determination. If CEST says "inside IR35," you may want to seek professional advice before accepting that result, because the tool can be conservative.

Contract Review vs Working Practices

One of the most common mistakes contractors make is assuming that if their contract says "outside IR35," they are safe. They are not. HMRC looks at the reality of the working relationship, not just the wording of the contract. If your contract says you have a right of substitution, but in practice you always do the work yourself, HMRC will disregard the contract clause.

Conversely, if your working practices genuinely support self-employment but your contract is poorly drafted, you may still be challenged. The ideal scenario is a contract that accurately reflects your working practices, and working practices that clearly demonstrate self-employment.

A proper IR35 review involves reading the contract alongside a detailed questionnaire about how you actually work. An ICAEW qualified accountant or a specialist IR35 solicitor can help with this. We do this regularly for contractors based in Birmingham's Digbeth, Bristol's Harbourside, and Leeds city centre.

Common Contract Clauses That Trigger IR35

Certain phrases in contracts are red flags for HMRC:

  • "The Contractor shall personally provide the Services", this removes substitution.
  • "The Contractor shall work under the direction and supervision of the Client", this suggests control.
  • "The Client shall provide the Contractor with a laptop, mobile phone, and office space", this points to employment.
  • "The Contractor shall be entitled to holiday pay and sick pay", this is a strong employment indicator.
  • "The Contractor shall attend weekly team meetings and performance reviews", this suggests integration.

If your contract contains these clauses, you are likely inside IR35 unless your working practices contradict them. A good IR35 review will identify these issues and suggest amendments where possible.

What Happens When IR35 Applies: The Deemed Employment Payment

Calculating the Deemed Employment Payment

When a contract is inside IR35, your limited company must calculate the deemed employment payment for each tax year. The calculation is:

Step 1: Add up all the income from the contract during the tax year.
Step 2: Deduct any amounts already taken as salary through payroll (your company pays you a salary, which already has PAYE and NI applied).
Step 3: Deduct 5% of the contract income as a flat-rate allowance for administrative and overhead costs. This is called the "5% allowance."
Step 4: Deduct any pension contributions made by the company.
Step 5: The remaining amount is the deemed employment payment. Your company must treat this as salary, deduct PAYE and employee NI, and pay employer NI.

The 5% allowance is a fixed percentage. It covers the costs of running your limited company, including accountancy fees, insurance, and software. You cannot claim actual expenses instead of the 5% allowance. It is all or nothing.

Worked Example: James, a London IT Contractor

James is an IT contractor based in Camden, London. He works through his limited company, JamesTech Ltd. In 2025/26, he has one contract with a large financial services client in Canary Wharf. The contract is inside IR35. His contract income is £92,800.

Deemed employment payment calculation:

  • Contract income: £92,800
  • Salary already paid through payroll: £12,570 (the personal allowance threshold)
  • 5% allowance: £92,800 × 5% = £4,640
  • Pension contributions: £8,000
  • Deemed employment payment: £92,800 - £12,570 - £4,640 - £8,000 = £67,590

JamesTech Ltd must process the deemed payment of £67,590 through payroll. The company pays employer NI of 13.8% on the amount above the secondary threshold (£9,100 for 2025/26). James pays employee NI at 8% on the amount above the primary threshold (£12,570) and 2% above the upper earnings limit (£50,270). He also pays income tax at 20% on the basic rate band and 40% on the higher rate band.

The total tax and NI cost is significantly higher than if James were outside IR35 and taking dividends. This is why contractors fight to stay outside IR35.

The 5% Allowance: What It Covers

The 5% allowance is intended to cover the overhead costs of running your limited company. It includes accountancy fees, professional indemnity insurance, software subscriptions like Xero or FreeAgent, bank charges, and other administrative costs. You cannot claim these expenses separately if you are inside IR35. The 5% is your lot.

If your actual overheads are lower than 5% of your contract income, you still get the full 5% deduction. If your overheads are higher, you cannot claim more. This is a fixed allowance, not a cap on expenses.

IR35 and Your Limited Company: Practical Implications

Dividends and Inside IR35 Contracts

If you have an inside IR35 contract, you cannot take dividends from that income. The deemed employment payment must be processed through payroll, and any profit left in the company after that can be taken as dividends, but only if it comes from other sources (e.g., outside IR35 contracts, investment income, or retained profits from previous years).

Many contractors with mixed portfolios (some inside IR35, some outside) need careful tax planning to avoid overpaying tax. The corporation tax position also becomes more complex. Your accountant needs to track which income is inside IR35 and which is outside.

Multiple Contracts and IR35

IR35 applies contract by contract, not company by company. You can have one contract inside IR35 and another outside IR35 at the same time. The deemed employment payment is calculated separately for each inside IR35 contract, though the payroll processing can be combined.

This is common for contractors who work for a mix of large and small clients. A contractor based in Manchester's MediaCity might have a six-month contract with a large broadcaster (inside IR35) and a separate project with a small production company (outside IR35). Each contract is assessed independently.

IR35 and Your Company's Year-End

The deemed employment payment is calculated for the tax year (6 April to 5 April), not your company's accounting year. This means you may need to do two calculations if your company year-end does not align with the tax year. Your accountant will handle this, but it is worth understanding that IR35 reporting is tied to the tax year, not your company's accounts.

Your company's corporation tax return (CT600) must include details of any deemed employment payments. HMRC cross-checks these against your payroll records. Getting this wrong can trigger an enquiry.

IR35 for Businesses That Hire Contractors

Your Responsibilities as a Client

If you run a medium or large business that hires contractors through their own limited companies, you are responsible for determining their IR35 status. You must issue a Status Determination Statement (SDS) to the contractor and the fee-payer (usually the agency) before any work starts. You must also have a process for handling disagreements.

The SDS must include the reasons for the determination. It is not enough to say "inside IR35." You must explain which factors led to that conclusion. HMRC can ask to see your SDS records, and if they find you have not complied, you can be held liable for the unpaid tax and NI.

Liability: Who Pays If You Get It Wrong

This is the part that keeps finance directors awake at night. If you are a medium or large client and you fail to issue an SDS, or you issue an incorrect SDS, and HMRC later determines the contractor was inside IR35, you are liable for the unpaid tax, employee NI, and employer NI. Plus interest and penalties.

The liability transfers up the chain. If the fee-payer (agency) cannot pay, HMRC comes to you. This is why many large businesses have become risk-averse and now classify most contractors as inside IR35 by default, even when the working practices might support outside IR35.

The Disagreement Process

If a contractor disagrees with your SDS, they must tell you in writing, setting out their reasons. You have 45 days to respond, either confirming your original determination or changing it. If you change it, you must issue a new SDS. If you confirm it, the contractor can ask HMRC to review the case, but HMRC will generally only intervene if there is evidence of carelessness or deliberate non-compliance.

For contractors, the disagreement process is weak. You cannot force the client to change their mind. Your only real options are to accept the determination, negotiate a rate increase to compensate for the higher tax, or walk away from the contract.

IR35 and Umbrella Companies

What Is an Umbrella Company?

An umbrella company is a payroll intermediary that employs contractors and processes their pay through PAYE. The contractor becomes an employee of the umbrella company, which handles tax, NI, pension, and other deductions. The contractor receives a net salary after deductions, similar to a permanent employee.

Umbrella companies became much more common after the 2021 reforms, because they offer a simple solution for contractors who are inside IR35 but do not want the administrative burden of running their own limited company payroll.

Umbrella vs Limited Company for Inside IR35 Work

If you are inside IR35, there is often little financial difference between using your own limited company and joining an umbrella company. Both result in PAYE and NI being deducted from your income. The main differences are:

  • Administration: An umbrella company handles everything. You do not need to file a company tax return or run payroll. Your limited company requires ongoing compliance, even if you are inside IR35.
  • Cost: Umbrella companies charge a fee, typically £20 to £30 per week. Your limited company has its own costs (accountancy, insurance, software).
  • Control: With your own limited company, you control your pension contributions and can retain profits for future dividends. With an umbrella, you are an employee and lose that flexibility.
  • Outside IR35 work: If you have any outside IR35 contracts, you need a limited company to receive that income. An umbrella company cannot help you there.

Many contractors keep their limited company open even when they are inside IR35, because they want the option to take outside IR35 work in the future. Closing your company and reopening it later is expensive and time-consuming.

Tax Avoidance Schemes to Avoid

HMRC is aggressively targeting tax avoidance schemes that promise to circumvent IR35. These schemes often involve loans, trusts, or offshore arrangements. They do not work. HMRC has won every major case against such schemes, and contractors who used them face huge tax bills, penalties, and in some cases, bankruptcy.

If a scheme promises you 90% take-home pay on an inside IR35 contract, it is almost certainly an avoidance scheme. Avoid it. Stick with your limited company, an umbrella company, or negotiate a rate increase. Do not risk your financial future on a scheme that HMRC will dismantle.

IR35 and HMRC Enquiries

How HMRC Identifies Targets

HMRC uses data from multiple sources to identify contractors who may be inside IR35 but are not complying. They look at:

  • Company tax returns (CT600) that show low salary and high dividends, compared to industry benchmarks for the contractor's profession.
  • Information from clients, including public sector bodies and large businesses, who must report their IR35 determinations.
  • Data from recruitment agencies, who are required to report payments to contractors.
  • Tip-offs from competitors, ex-employees, or disgruntled clients.

HMRC also conducts targeted campaigns. In recent years, they have focused on IT contractors, management consultants, and engineers. If you work in one of these sectors and your tax return looks unusual, you are more likely to be selected for an enquiry.

What Happens During an IR35 Enquiry

An IR35 enquiry typically starts with a letter from HMRC asking for information. They will want to see your contracts, your working practices, your company records, and your tax returns. They may ask to speak to your clients. The process can take 12 to 18 months, sometimes longer.

If HMRC decides you were inside IR35, they will issue a tax assessment for the deemed employment payment, plus interest from the date the tax should have been paid, and penalties. The penalties can be up to 100% of the tax due if HMRC considers the non-compliance deliberate.

You can appeal the assessment. The first stage is an internal review by HMRC. If that fails, you can take your case to the First-tier Tribunal (Tax Chamber). Tribunal cases are public, time-consuming, and expensive. Most contractors settle before reaching tribunal.

How to Prepare for an Enquiry

The best defence against an IR35 enquiry is good documentation. Keep copies of every contract, every variation, and every email that relates to your working practices. Keep a diary of how you actually work. If you have a right of substitution, keep records of any substitute you have used, or at least evidence that the right exists and is genuine.

If you are outside IR35, your contract and your working practices must match. If HMRC finds a mismatch, they will argue that the contract is a sham. A well-drafted contract, reviewed by an IR35 specialist, is your first line of defence. Your second line is evidence of your actual working practices.

We help contractors across the UK prepare for IR35 enquiries. Whether you are based in Glasgow's Merchant City, Edinburgh's Leith, or Sheffield's Kelham Island, the principles are the same. Be prepared. Be honest. And get professional advice before HMRC comes knocking.

IR35 and Your Exit Strategy

IR35 and Business Asset Disposal Relief

Business Asset Disposal Relief (BADR), formerly Entrepreneurs' Relief, allows you to pay 14% CGT on the first £1 million of gains when you sell or close your company. But BADR has strict conditions. You must have been an officer or employee of the company for at least two years, and you must hold at least 5% of the shares and 5% of the voting rights.

If you have been inside IR35 for the entire life of your company, HMRC may argue that you were not genuinely trading, and therefore BADR does not apply. This is a complex area. If you are planning to close your company and claim BADR, you need to show that your company was a genuine business, not just a vehicle for disguised employment.

Having some outside IR35 contracts, or other business activities, strengthens your BADR claim. If you have been inside IR35 exclusively, speak to an ICAEW qualified accountant before making any disposal. The tax difference between BADR and the main CGT rate is significant: 14% vs 24% for higher rate taxpayers.

Closing Your Company After IR35

If you decide to stop contracting and close your company, you have two main options: Members' Voluntary Liquidation (MVL) or striking off. An MVL is more expensive but allows you to distribute retained profits as capital gains, qualifying for BADR. Striking off is cheaper but treats retained profits as dividends, taxed at dividend rates.

If you have been inside IR35, your company may have retained profits from previous years when you were outside IR35, or from non-IR35 income. These profits can be distributed, but the tax treatment depends on how you close the company. This is another area where professional advice is essential.

Action Checklist for Contractors and Businesses

For Contractors

  1. Know your client's size. If the client is medium or large, they determine your IR35 status. If they are small, you do.
  2. Get your contract reviewed. Have an IR35 specialist review your contract before you sign. If it contains employment-style clauses, ask for amendments.
  3. Use the CEST tool. Run your contract through HMRC's CEST tool. Save the output. It is evidence if HMRC challenges you later.
  4. Document your working practices. Keep a diary of how you work. Note any substitutions, your control over your work, and the absence of mutuality of obligation.
  5. Separate your finances. If you have a mix of inside and outside IR35 contracts, keep separate records. Your accountant needs to know which income is which.
  6. Plan your pension. Pension contributions reduce your deemed employment payment. If you are inside IR35, maximise your pension contributions to reduce your tax bill.
  7. Review your insurance. Professional indemnity insurance is essential for outside IR35 contracts. Inside IR35, your client's insurance may cover you, but check.
  8. Speak to an accountant. IR35 is complex. A single mistake can cost you thousands. We are ICAEW qualified accountants who specialise in contractor tax. Contact us for a review of your IR35 position.

For Businesses Hiring Contractors

  1. Assess your size. Are you medium or large? Use the turnover, balance sheet, and employee tests. If you are small, the contractor is responsible for their own IR35 status.
  2. Implement a process. You need a consistent process for determining IR35 status for every contractor. Use CEST or a commercial tool. Document every determination.
  3. Issue an SDS. Before work starts, issue a Status Determination Statement to the contractor and the fee-payer. Include your reasoning.
  4. Handle disagreements. Have a process for responding to contractor disagreements within 45 days.
  5. Review your contracts. Standard employment-style contracts will trigger inside IR35 determinations. If you want outside IR35 contractors, use contracts that reflect self-employment.
  6. Train your hiring managers. The people who engage contractors need to understand IR35. They should not be telling contractors when to work or how to do their jobs.
  7. Keep records. HMRC can ask to see your SDS records for up to six years. Keep everything.
  8. Get advice. The liability for getting IR35 wrong is significant. Speak to us if you are unsure about any part of the process.

Further Reading and Resources

IR35 is a complex area, and this guide covers the fundamentals. For more detail, explore our other resources:

If you need specific advice on your IR35 position, whether you are a contractor or a business, get in touch. We will review your contracts, assess your working practices, and help you navigate the off-payroll working rules. Every contractor's situation is different, and general guidance is no substitute for tailored professional advice.