What is IR35? And How Does it Impact the Self-Employed?
As a contractor you’ve most likely heard of IR35, but it’s equally likely that you’ve never fully understood the implications of the rule and whether they apply to you. In this article we’ll clarify this complex legislation and explain the upcoming changes for 2021.
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So what is IR35? And how does it impact the self-employed? Read on to find out more.
IR35 rules - what does IR35 stand for?
If you are self-employed or planning on becoming self-employed you’ll need to be aware of and understand IR35.
IR35 applies to any contractor that works for a limited company, to determine whether their relationship is more like that of an employee- employer rather than a company retaining the services of a contractor.
IR35 first came into law in 2000, when it was implemented by the then Chancellor of the Exchequer Gordon Brown. It was put in to place because the Government thought contractors and employers were exploiting a tax loophole.
Because it is more tax efficient for a company to hire a contractor through a limited company, some companies were using this model when in fact the contractor had duties more typical of an employee.
Where this relationship is in place, but not properly reported by either party, the contractor is referred to as a disguised employee. Disguised employees are usually hired by limited companies through an intermediary, for example an agency.
Disguised employees can save the employer a large sum of cash because they don’t have to pay the employers’ National Insurance contributions of 13.8% or offer any employee benefits.
The legislation was abused by a common tactic known as the Friday – Monday scenario. Limited companies would have employees leave their role at the end of the week on Friday only to return to the same role and responsibilities on the following Monday, this time as a contractor so they would pay significantly less tax.
When functioning effectively, IR35 protects contractors and companies against the other party attempting to unfairly dupe the tax system, it also guards against HMRC losing tax yield.
When does IR35 start? What were the IR35 2020 changes?
The IR35 changes were due to come into effect in 2020, but they have been deferred one year by the COVID-19 pandemic; they will now come into place on 6 April 2021.
The changes will apply to medium and large private sector businesses, who will now be responsible for determining the IR35 status of contractors, and ensuring they pay the correct level of tax.
If you work for a medium or large company and you are a contractor that is deemed to be outside IR35, you will be responsible for managing your taxes.
Small businesses are exempt from the changes. HMRC defines small companies as those with an annual turnover of no more than £10.2 million, a balance sheet of no more than £5.1 million and no more than 50 employees.
Many in the business community think the changes to IR35 are ill conceived, because clients of contractors are not equipped to make decisions on tax status. Although it's fair to say that others feel that this is an appropriate change levelling up the playing field between employees and contractors.
How does IR35 work?
IR35 attempts to identify disguised employees to ensure they pay the correct amount of tax. Because of the nature of how IR35 operates, it is possible that IR35 can be wrongly applied to those correctly working in a limited company structure.
There are some grey areas which make the legislation difficult to apply objectively. This is why many companies and workers employ experts to represent and advise them when trying to determine if they are compliant with the legislation, whether they are being investigated by HMRC, or they’re just trying to get their house in order ahead of a new tax year.
Another reason why IR35 is hard to follow is that it applies to personal service companies (PSCs); limited companies with a sole or majority director or shareholder that is in charge of the company’s services. However this term hasn’t been clearly defined by HMRC.
When HMRC suspects a case of disguised employment they will assign an investigator to look into the matter. During the process the investigator closely examines the de facto nature of the employer-contractor relationship, rather than relying on what is set out in the contract agreed by the two parties.
Essentially, an HMRC inspector will use the actual nature of the working relationship to create a ‘notional contract’ and determine whether individuals are ‘inside’ IR35 (employee status) or ‘outside’ (contractor).
What are the IR35 rules?
Deemed employees should pay the same tax as the other employees in a limited company in the same role. However, as a contracted worker they won’t benefit from the same entitlements as a regular employee, which include: sick pay, holiday allowance and pensions.
This is one of the reasons that IR35 legislation has many critics. If you are not compliant with IR35 legislation, as a contractor that has abused the tax system you will have to pay back any missing tax including any interest and penalties that are applied, despite the fact that you will also not have benefited from any of the support structure of benefits offered to ‘actual employees’.
HMRC can investigate historical income tax due up to six years, those found to have not paid the correct tax could face severe financial repercussions.
It depends on whether you are considered inside or outside IR35.
What does inside IR35 mean?
If you are inside IR35 you are treated as an employee of your client for tax collection purposes and you’ll be enrolled on PAYE. You will have to pay National Insurance and Income Tax, which the client will deduct from your pay (from 2021).
Currently if you are inside IR35 you will be responsible for paying your contributions, you’ll usually be entitled to pay them as an annual ‘deemed payment’ at the end of the tax year. It is worth discussing this with your accountant to ensure you pay the correct amount.
What does outside IR35 mean?
Contractors outside of IR35 will be able to continue to draw a salary, take the remainder of their earnings as a dividend and pay themselves in the most tax efficient way. They will be responsible for managing their own taxes.
Does IR35 apply to sole traders?
IR35 does not apply to sole traders, because you are operating as a self-employed person without a limited company.
IR35 will affect you as a contractor that works for a limited company. If you work through a limited company that employs contractors, acting as an intermediary or supplier between you and the client – usually a recruitment agency, your tax contributions should be handled by the umbrella company through PAYE.
If a contractor is found to be working for an employer, the liability rests with the employer, however as a contractor in this situation you could face a loss of earnings, due to the tax owed by your client.
As a contractor you’ll want to stay on the right side of HMRC. It’s important that you understand how the legislation works and take prudent steps to ensure you aren’t considered to be manipulating the system.
Business banking and accounting software for the self-employed
As a contractor working for a variety of clients you may already use business banking services to manage your business accounts, but are you getting the best deal from your business banking? Check out our business bank accounts comparison table to find out.
With the changes to how you as a contractor manage your taxes being imminent, now is a great time to ensure your accounts are in order to save you from any nasty surprises from the tax man.
Accounting software could make your life much easier; you’ll be able to easily track your expenses, invoices and bills and have many more features available at your fingertips to make accounting the least of your worries.
Finance Director at NerdWallet UK and business adviser to SME's Nic is spokesperson for small and growing businesses with a strong understanding of the financial needs of business Read more