IR35 Explained A UK Guide for Contractors and Employers

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The IR35 legislation has long been a complex and often misunderstood part of UK tax law. Whether you’re a self-employed contractor, a limited company director, or a business that hires off-payroll workers, understanding IR35 is crucial for staying compliant and avoiding unexpected tax liabilities.

In this post, we explain what IR35 is, who it applies to, how employment status is determined, and what steps both contractors and employers should take to stay on the right side of the rules in the 2025/26 tax year.

What Is IR35?

IR35 formally known as the Intermediaries Legislation is a set of tax rules designed to prevent disguised employment. It aims to identify individuals who supply services to clients through an intermediary (such as a limited company) but who would be considered employees if the intermediary wasn’t used.

Introduced in 2000, IR35 ensures that these workers pay broadly the same Income Tax and National Insurance as employees.

The legislation is enforced by HMRC and applies across both the public and private sectors.

Why IR35 Matters

IR35 officially known as the off-payroll working rules exists to stop disguised employment. HMRC estimates that non-compliance with IR35 costs the Treasury hundreds of millions of pounds in lost tax revenue every year.

When contractors work like employees in practice but invoice through a limited company (known as a personal service company, or PSC), HMRC can treat them as inside IR35. This means they should pay broadly the same Income Tax and National Insurance (NICs) as regular employees.

For businesses, recruitment agencies, and contractors alike, misunderstanding or ignoring IR35 can be costly. If HMRC decides IR35 applies, it can lead to:

  • Backdated Income Tax and NICs for up to six years, depending on the situation
  • Additional penalties and interest charges on top of the unpaid tax
  • Reputational damage both for the contractor and the end client or agency
  • Lost contracts or reduced earnings if clients avoid using contractors altogether due to perceived risks

Understanding whether IR35 applies and what to do if it does is vital.

IR35 applies to anyone working through an intermediary usually a personal service company (PSC)  who would otherwise be an employee if that intermediary didn’t exist.

In practice, IR35 can apply to:

  • Contractors and freelancers who operate through their own limited company or PSC.
  • Clients (end-users) who hire workers through intermediaries, such as PSCs.
  • Agencies and recruiters who supply contractors to end clients.

Key point: The rules are different depending on the size of the end client and whether they are in the public or private sector.

  • Public sector and medium or large private sector clients must decide whether IR35 applies to each contract. If it does, they must deduct Income Tax and NICs at source just like for employees.
  • If the client is a small private company, the responsibility for deciding IR35 status and paying any tax remains with the contractor’s PSC.

Tip: Many contractors wrongly assume IR35 doesn’t apply if they’re hired through an agency but if the working relationship is really one of employment, the rules still apply.

For full details on how IR35 applies in different sectors and who is responsible for tax, see GOV.UK: Off-payroll working rules.

Key Rule: Employment Status

At the core of IR35 is one simple but crucial question:

“Would this contractor be an employee if they were working directly for the client without their limited company or intermediary in place?”

If the answer is yes, then the contract is inside IR35. This means employment taxes income Tax and National Insurance  must be paid as if the worker were directly employed.

If the answer is no, then the contract is outside IR35. The contractor can be paid gross and retain the tax benefits of working through their own limited company, such as drawing dividends and claiming business expenses.

Key point: HMRC will look beyond your contract and assess the actual working relationship. A contract that looks “outside IR35” on paper may be deemed “inside” if, in practice, you work under similar terms to an employee.

Inside vs Outside IR35: What’s the Difference?

Understanding the difference between inside IR35 and outside IR35 is essential for any contractor, agency, or client working with off-payroll labour.

Here’s how it breaks down:

StatusDescriptionTax Implication
Inside IR35The contractor is deemed to be working as an employee for tax purposes.Income Tax and National Insurance are deducted at source by the client or fee-payer, just like for a normal employee.
Outside IR35The contractor is genuinely self-employed, running their own business and taking on business risk.The contractor is paid gross and manages their own tax through Self Assessment, keeping tax efficiencies like dividends and allowable expenses.

Key point: If you’re inside IR35, you can’t simply pay yourself in dividends to reduce your tax the tax treatment should mirror employment.

For contractors, this can mean a significant reduction in take-home pay if your contract is found to be inside IR35.

For more details, see GOV.UK: Off-payroll working (IR35).

Who Determines IR35 Status?

Since 6 April 2021, the rules for deciding IR35 status in the private sector have changed. The responsibility now depends on the size of the client organisation.

  • Medium and large businesses must determine whether a contract is inside or outside IR35 and ensure the correct tax is deducted and paid to HMRC.
  • Small businesses are exempt from this requirement in these cases, the contractor’s limited company (PSC) remains responsible for assessing IR35 status and paying any tax due.

A business is classed as small if it meets two out of these three conditions:

  • Annual turnover of  £15million (previously £10.2 million) or less
  • Balance sheet total of Up to £7.5 million (previously £5.1 million)
  • 50 employees or fewer

This means if you’re a contractor working with a small private company, you remain in charge of your own IR35 compliance just as you did before the rules changed.

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What Factors Determine IR35 Status?

HMRC uses several key tests to assess whether a contract is one of employment or self-employment:

  • Supervision, Direction, and Control (SDC)
    • Does the client control how, when, and where the contractor works? If so, it’s more like employment.
  • Substitution Clause
    • Can the contractor send someone else to do the work? A genuine right of substitution supports self-employment.
  • Mutuality of Obligation (MOO)
    • Is the client obliged to provide work and the contractor obliged to accept it? This suggests employment.
  • Financial Risk
    • Does the contractor bear any financial risk (e.g. correcting mistakes at their own cost)? If yes, that leans towards self-employment.
  • Provision of Equipment
    • Using your own tools and equipment suggests you’re in business on your own account.

CEST: HMRC’s IR35 Status Tool

HMRC provides a free online tool called Check Employment Status for Tax (CEST). It helps clients and contractors assess IR35 status based on contract terms and working practices.

Check Employment Status for Tax (CEST)

Note: CEST is controversial and may not always give clear or accurate results. It’s best used with professional advice.

Tax Treatment Inside IR35

If your contract is determined to be inside IR35, your income is treated as if you were an employee for tax purposes but without most employee benefits.

What this means in practice:

  • Income Tax and National Insurance contributions are deducted at source under PAYE.
  • You do not receive statutory employee rights, such as sick pay, holiday pay, or pension contributions from the client.
  • You lose the ability to claim many common business expenses that would normally reduce your tax bill, such as travel costs, training, or equipment purchases (except for a limited 5% allowance for certain administrative costs, which doesn’t apply where the client handles the tax).

The fee-payer (usually the end client or the recruitment agency) is responsible for:

  • Deducting Income Tax and NICs from your invoice amount.
  • Reporting payments to HMRC through Real Time Information (RTI), just like for regular employees.

This can significantly reduce a contractor’s take-home pay, which is why getting IR35 status right is so important.

How to Stay Compliant (Contractors)

If you’re a contractor:

  • Review your contracts carefully before accepting any engagement
  • Avoid boilerplate contracts that suggest control or exclusivity
  • Document your actual working practices not just what’s in the contract
  • Get a professional IR35 contract review
  • Consider taking out IR35 insurance if working through a limited company

How to Stay Compliant (Clients and Employers)

If you hire contractors:

  • Assess every contract using IR35 tests (or CEST)
  • Issue a Status Determination Statement (SDS) for each contractor
  • Keep a record of assessments and communication with agencies
  • Operate PAYE if the contractor is inside IR35
  • Review contracts regularly, especially if working arrangements change

Failing to apply the rules properly could make you liable for unpaid tax and penalties.

Recent Updates and Future Outlook (2025/26)

As of the 2025/26 tax year, there are no major legislative changes expected to IR35 but HMRC continues to increase enforcement. Areas of focus include:

  • Media and IT sectors with high contractor volumes
  • Public sector bodies (e.g. NHS, local councils)
  • Contractor umbrella companies, which must now comply with more strict reporting rules

Contractors and clients should expect more scrutiny and investigations, particularly where CEST assessments lack evidence.

IR35 and Umbrella Companies

Some contractors work via umbrella companies to avoid IR35 risks. This means:

  • You’re treated as an employee of the umbrella company
  • PAYE tax and NICs are deducted
  • You have access to certain employee rights
  • But you lose many of the benefits of self-employment

Umbrella arrangements can be useful but need to be well understood. Always check if the umbrella is FCSA-accredited or recommended by your accountant.

Summary: IR35 Explained

Here’s a quick snapshot of the key differences between inside IR35 and outside IR35:

AspectInside IR35Outside IR35
Employment statusDeemed employee for tax purposesSelf-employed contractor
Tax treatmentPAYE and NICs deducted at sourceTax paid through Self-Assessment
Contractor tax benefitsLimited – minimal ability to claim expenses or pay dividendsBroader can claim allowable expenses and pay dividends through a PSC
Who determines statusClient (if medium/large business)Contractor (if client is small or contract pre-2021 changes)

The bottom line: understanding IR35 and getting each contract’s status right is essential to avoid unexpected tax bills, penalties, and reduced earnings.

For full guidance, see GOV.UK: IR35 Off-payroll working rules.

Final Thoughts and how Accounting Wise can help

IR35 can be a complex and costly issue if misunderstood. Whether you’re a contractor looking to protect your income or a business hiring flexible talent, getting your IR35 status right is critical to avoiding tax penalties and ensuring a fair working relationship.

At Accounting Wise, we help businesses and contractors:

  • Review contracts and working arrangements
  • Ensure IR35 compliance
  • Manage off-payroll tax reporting
  • Understand risks and responsibilities

Need help understanding your business finances? Get started today for expert advice on improving your profits.

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