What is Inside and Outside IR35?
Navigating the intricate landscape of UK tax legislation is no easy feat, especially for contractors. Amidst the myriad of regulations, one term stands out prominently: IR35. But what is the meaning of ‘inside IR35’ and ‘outside IR35’, and why does it matter?
In this comprehensive guide, we delve deep into the heart of IR35. Whether you’re an aspiring contractor or a seasoned veteran seeking clarity, this guide aims to demystify IR35, empowering you with the knowledge to make informed decisions and remain compliant.
Inside IR35 Meaning
Working inside IR35 means that you have been caught by the IR35 rules, and HMRC regards the service you provide to be one of employment. You are considered an employee for tax purposes rather than a self-employed individual running their own business.
If you work inside IR35, you are subject to the same income tax and National Insurance contributions as a permanent employee. You can not utilise the salary and dividend structure in the same way you can while working outside IR35 via a limited company. Instead, you are paid via PAYE.
Paying a contractor via PAYE requires a fee-payer to run payroll. Most clients do not want to take contractors onto their payroll directly; instead, they prefer to engage contractors via an intermediary such as an umbrella company.
Implications of Being Inside IR35
If you are a permanent employee considering contracting for the first time, accepting an inside IR35 contract is more straightforward than working outside IR35 via a limited company. You do not need to incorporate a limited company, hire an accountant, or submit a self-assessment tax return.
Once you have chosen an umbrella company, all you need to do is submit your timesheets. The umbrella company will handle the administrative tasks of running payroll and paying the relevant taxes to HMRC.
The situation is more complicated if you are an existing contractor considering switching from working outside IR35 to working inside IR35, as you need to decide what to do with your limited company. Do you keep it going, make it dormant, or close it completely?
Our Closing Your Limited Company and Dormant Limited Company guides can help you decide.
Trading While Inside IR35
Once a project is found to be inside IR35, an intermediary must be chosen. Although umbrella companies are by far the most common trading solution, they are not the only option available to contractors:
i. Umbrella Company
An umbrella company acts as an intermediary between the contractor and the end client, charging a small margin to handle the administrative task of running PAYE. The contractor submits a timesheet, and the umbrella company invoices the client.
Once the client pays the invoice, the umbrella company deducts income tax, National Insurance, and employer costs (employer’s National Insurance, apprenticeship levy, and umbrella margin). The net amount is then paid into the contractor’s personal bank account.
ii. Agency PAYE
With agency PAYE, the contractor is enrolled into the recruitment agency’s PAYE system and effectively becomes their employee for the duration of the contract. The agency pays the contractor a fixed rate while charging the client an uplifted amount to cover their fee and administrative costs.
The agency deducts Income Tax and National Insurance from the contractor’s rate and pays the net amount into their personal bank account. There are rarely additional costs to the contractor as the agency factors administrative and employer costs into what they charge the end client.
Although this may make it seem like Agency PAYE is better than operating through an umbrella company, a contractor’s net take home is usually the same. End clients should offer inflated rates for umbrella company contractors to reflect that they pay the employer’s costs directly. However, how accurately rates are inflated has been a point of contention since the IR35 rules emerged.
iii. Limited Company
Most contractors are unaware that you can technically continue working through your limited company while working inside IR35. Our guide to IR35 and Limited Companies explains how this works in theory.
In reality, very few contractors work this way as end clients refuse to work with contractors on an inside IR35 basis unless it is via an umbrella company or agency PAYE.
iv. Fixed-Term Contract
Contractors working on fixed-term contracts are employed directly by the end client for a specific period. As the contractor is an employee, there is no intermediary, and the IR35 rules do not apply.
By law, the employer treats the contractor the same way they treat other employees on a permanent basis. The contractor receives equal treatment to other employees for the contract duration. They have unfair dismissal and redundancy rights, receive the same pay, and pay the same taxes.
It’s worth noting that, although there are technically many options available to inside IR35 contractors, recruitment agencies and end clients frequently specify that they will only accept contractors working through an umbrella company.
Outside IR35 Meaning
Being ‘outside IR35’ means that you are running a genuine business and, therefore, operating outside of the IR35 rules. As an outside IR35 contractor, you are a limited company director, invoicing your client directly and using the company revenues and profits in a way that suits you, just like any other small business owner.
Financially speaking, working outside IR35 means taxes are not deducted at source, and you are not subject to direct PAYE via the fee-payer. Instead, the client pays the entire fee amount to your limited company as revenue. This revenue is subject to corporation tax and a mixture of income tax and dividend tax, depending upon how it is withdrawn.
As you are not subject to PAYE, you must ensure you pay the right amount of tax by submitting a self-assessment tax return at the end of the year. Most contractors working outside IR35 employ the services of a specialist contractor accountant, as the nuances of running a limited company can be tricky.
Trading While Outside IR35
Choosing a legal structure is one of the most critical decisions outside IR35 contractors must make. There are several options available:
i. Limited Company
Almost all outside IR35 contractors choose to operate via a personal service company (‘PSC’). A PSC is a limited company set up by a contractor to provide their services; they are usually the sole shareholder and company director.
As a limited company is a distinct legal identity in its own right, the contractor’s personal assets are not at risk should the company face financial hardship.
ii. Sole Trader
A sole trader is a self-employed individual who is the sole owner of their business. As a sole trader, there is no distinction between yourself and the business; you are considered the same entity. You have absolute control over how the business is run and are entitled to keep 100% of the profits.
Although technically possible, outside IR35 contractors rarely work as sole traders. Most end-hirers won’t work with them as there is a risk that the sole trader could seek to claim employment rights from the hirer (as is common in the construction industry).
From a contractor’s point of view, not only are there financial benefits involved with working through a limited company, but sole traders also face virtually unlimited liability. Their personal assets could be at risk in the face of litigious clients.
See our guide to IR35 and Sole Traders for further details.
iii. Umbrella Company
An outside IR35 contractor can, in theory, decide to work through an umbrella company. As with an inside IR35 contract, the umbrella company would invoice the client and then deduct all relevant taxes before paying the contractor net.
In practice, this is rarely done as it removes any ability to distribute earnings tax-efficiently. The only time outside IR35 contractors consider working through an umbrella company is if the contract is short or if they are considering moving to a permanent position. In these cases, they may not want the administrative burden of running a limited company.