IR35 Complete Guide

New contractors need to be aware of a piece of government legislation known as IR35. The legislation was put in place some 15 years ago to prevent tax avoidance by way of disguising employment. The legislation lays out very clear criteria by which contractors are judged; those who fall under the scope of IR35 are subject to additional reporting regulations. Any contractor found in violation of IR35 could face significant penalties as well as increased tax and National Insurance contributions.

IR35 Details

As the 1990s rolled into the 2000s, it became apparent that a handful of small business owners had discovered a way to avoid National Insurance and reduce income tax by structuring their companies in a way that would allow income to be dispersed as dividends to owners, usually as family members. This was construed as tax avoidance. To address the problem, the government came up with IR35.

The key component of the legislation is determining whether the contractor is fulfilling the same role of a salaried worker to an extent that the only discernible difference between the two is legal employment status. IR35 draws a very fine line governed by a number of complex rules that can make the legislation confusing.

Whether you, as a new contractor, fall under the scope of IR35 or not depends on your individual circumstances. How your contracts are structured, how you perform the work and with whom you contract all play a role in determining your status under IR35. Below are some guidelines to help you better understand where your company might fall in relation to this legislation.

Disguised Employment Qualification

The motivation behind IR35 was to end the practice of employers and employees disguising employment in order to avoid taxes and National Insurance payments. In short, disguised employment is employment that was previously carried out by a salaried worker whose status was terminated for the purposes of establishing a limited company and returning to do the same work. Similarly, a contractor completing the same full-time work that a salaried worker would have completed under a normal employer-employee relationship may be considered disguised.

The best way to understand IR35 is to ask whether your contract provides you with the same benefits you would receive if you were a salaried worker instead. For example, does a contract include pension contributions or sick pay? If so, your business may fall within the scope of IR35.

The Benefits of Disguised Employment

What are the benefits of disguised employment? Companies may sometimes choose to employ this practice in order to avoid paying their share of National Insurance – nearly 14%. Employees may elect to disguise employment in order to reduce their National Insurance payments and overall tax obligations.

Framed in those terms, there are some who maintain that the former practice of disguised employment was nothing more than tax fraud. Thus, the legislation was put in place in 2000. Contractors whose businesses fall within the scope of IR35 can still maintain their limited companies, but their incomes will still be taxed at the same rate as salaried employees and their National Insurance contributions will remain the same.

Determination of Self-Employment

Not all benefits offered by a client fall under the scope of IR35. As previously stated, IR35 can be very complex in its application. As a small business owner and director of a limited company, the average contractor is eligible to enjoy some benefits of employment without crossing the line. In other words, benefits received are not the sole indicator of IR35 status. Below is a short list of four characteristics that can better help you determine self-employment through a limited company subject to IR35 legislation:

• Contract Termination – Salaried employees must provide employers a notice period prior to leaving employment. Contractors have no such obligation. They can terminate contracts at any time without notice. A contract stipulating a notice period for termination may indicate an IR35 situation.

• Financial Risk – Contractors assume all of the financial risk of their business activities. This includes purchasing equipment and supplies, providing transportation, and funding the other aspects of conducting business out of pocket. If those expenses are all born by a client, you may have an IR35 situation.

• Time Management – A person who is truly self-employed has complete freedom to manage his/her own time. He/she is able to complete the contract with quite a bit of latitude, where a salaried worker is managed very closely by the employer. How your time is managed may determine, in part, your IR35 status.

• Extra Benefits – The red flag for most contractors are the extra benefits provided by a client. Under IR35, contractors are not entitled to receive benefits from clients including paid training, pension contributions, holiday entitlement, sick pay, etc.

Should any of these four guidelines indicate that you are 'caught' by IR35, this does not mean you cannot continue to work as the owner of a limited company on behalf of your client. However, it does mean you have to report your income in a different way. You are also subject to different rules regarding deductions for business expenses.

Also, keep in mind that there are times when your contracts are clearly outside of the scope of IR35 and other times when they are inside. This is where you need help from an accountant. You need to be able to keep the revenues from both types of work separate so that they can be reported correctly.

Umbrella Company Option

There may be a temptation to work under an umbrella company rather than having one's contracting activity be governed by IR35. This may be a viable option for some, but it is not necessarily the right choice for you. Working under an umbrella company makes the contractor a legal employee of that company resulting in less take-home pay and higher taxes. The contractor has to compare the financials of both scenarios to figure out which one is more tax advantageous.

In many cases, it is beneficial to still work inside of IR35 rather than subjecting oneself to umbrella company employment. The benefits include:

• A 5% tax allowance from HMRC to cover administrative costs (unavailable to umbrellas)
• An additional 5% allowance for things such as travel and training (unavailable to umbrellas)
• Increased take-home pay by taking advantage of the Flat Rate VAT scheme (unavailable to umbrellas)
• Lower VAT management fees assessed by your accountant as compared to those assessed by an umbrella
• The opportunity to take future contracts outside of IR35.

When you work for an umbrella company, you are legally employed by that company. Therefore, you are subject to how your umbrella does business – this includes the contracts they offer and the clients they work with. By running your own limited company under IR35, you still have the opportunity to control the direction of your company. In the future, you can secure additional contracts outside of IR35, thereby enjoying more take-home pay, greater tax efficiency, and easier income reporting.

Just to give you an idea of take-home pay under both scenarios, the average contractor working at a daily rate of £250 will take-home approximately £29,400 working under an umbrella company. Inside IR35, that same contractor could take home as much as £39,120. That difference of nearly £10,000 is well worth the extra effort required to meet the obligations of IR35.

Taxes and National Insurance

The complexities of IR35 do not allow us to include all the details on this page. However, we have put together some of the most important points to help you understand how taxes and National Insurance work under the legislation. To begin with, contractors whose business operations fall under the scope of IR35 pay full income tax and National Insurance on the money they receive as salary.

In most cases, total turnover equals salary. The legislation allows you to deduct the 5% allowance for the administration of your limited company to figure out what is known as your 'deemed payment'. Any additional expenses included in the secondary 5% allowance can also be conducted when calculating the deemed payment. Finally, you must work out any salary or Employers NIC already paid.

This final number determines how much tax you owe to the government. The benefit of working under IR35 as a truly independent contractor, as opposed to working for an umbrella company, is that of tax efficient accounting that will keep this final number as low as possible. Some of the things your accountant can explore include:

• taking advantage of the Flat Rate VAT scheme
• taking advantage of a pension scheme to reduce your deemed payment
• taking advantage of as many expenses as is legally allowed under IR35
• structuring your expenses under the 5% allowance to prevent the corporation tax.

As always, the burden of maintaining tax compliance falls on the director of a limited company. For that reason, some contractors who fall under the scope of IR35 prefer to work for umbrella companies instead. That choice is entirely up to you. Yet we believe you will earn more and enjoy greater freedom working as a contractor under IR35 than you would as an umbrella company employee.

If you are just starting a new limited company and you have questions about IR35, please do not hesitate to contact us. We can help guide you through the legislation to determine where you stand. Should you decide to continue as a contractor under the legislation, we have the expert accounting services you need to make sure you maintain full compliance with the law.