What Is The Cost of IR35?
Since IR35 was first introduced, contractors have tried to ensure they operate as a genuine business outside IR35. Operating in this way ensures they can pay themselves a tax-efficient salary and dividend split. Drawing a small salary minimises income tax exposure and employer and employee national insurance (NI) contributions.
But what happens to those contractors that are caught by the IR35 rules? What is the cost of IR35?
In the following article, we try to quantify the cost of IR35 by comparing various scenarios for two contractors, Jack and Jill. Both charge a daily rate of £500; however, Jack works inside IR35 via an umbrella company, while Jill works outside IR35 via a limited company.
The following calculations assume 230 working days, and use tax rates from 2024/2025.
The Cost of IR35
At £500 per day, Jack has annual taxable earnings of £100,705, pays £33,388 in tax and has a take-home of £67,317.
Jill has annual taxable earnings of £91,254, pays £16,956 in tax and has a take-home of £74,298. The lower taxable earnings and disparity in the amount of tax paid by Jill owe to the fact that her limited company has already paid £23,267 in corporation tax.
That is a difference of £6,981 per year, or 9%. To earn an equivalent take-home while working inside IR35, Jack must charge a daily rate of £590, an 18% increase from what he currently earns. The cost of being caught by IR35 is, therefore, significant.
The difference in take-home is driven by Jack and Jill paying different types of tax. Jack’s income is taxed at source, so he pays income tax and Employee National Insurance. Jill’s income is structured in such a way that she pays no income tax or Employee National Insurance, instead paying a combination of corporation tax and dividend tax.
While Jack and Jill both pay Employer’s National Insurance contributions on their salaries, Jack has to pay a whopping £12,641 for the year, while Jill pays just £479. This is the most common complaint regarding IR35 and working through an umbrella company, classifying contractors as employees and then making them responsible for paying taxes usually paid by an employer. See our guide to Umbrella Company National Insurance for further details.
But what happens if the daily rate changes? Does this impact the difference in Jack and Jill’s take-home pay? The answer is, surprisingly, yes.
At £300 per day, Jack has an annual take-home of £44,116, while Jill’s is £51,899, a difference of 15%. At £700 per day, Jack has an annual take-home of £85,772, while Jill’s is £91,058, a difference of 6%.
Although the inequality appears to decrease the higher the daily rate charged, this isn’t actually beneficial. It simply reflects that the difference between the dividend and income tax rates reduces the more you earn. Higher earners pay higher tax rates on the income that falls into the respective bucket, a key reason working outside IR35 via a limited company is so attractive. It facilitates effective tax planning.
Effective Tax Planning
The above calculations assume that Jill withdraws all cash from her limited company in the year it was earned and has no allowable expenses. While this allows us to identify a general parallel between inside IR35 and outside IR35 take-home rates, it does not reflect reality.
In truth, working outside IR35 through a limited company allows Jill to choose how she withdraws her money from the business. She can select from several different strategies to minimise her tax liabilities effectively. Allowable expenses reduce the corporation tax liability, delaying payment of a dividend to the following tax year reduces the amount captured by higher rate tax brackets, and leaving revenue in the company as retained earnings enables claiming Business Asset Disposal Relief (‘BADR’) upon winding up.
Of these, BADR is the most effective way contractors can reduce their tax bill. Our guide to Closing Your Limited Company explains BADR in detail; however, to summarise, BADR turns a dividend into a capital repayment. Instead of paying the relevant dividend tax rate, contractors pay a reduced capital gains rate on qualifying disposals of 10%.
When considering tax planning, the disparity between inside IR35 and outside IR3 take-home increases significantly. Take the £500 per day example above. If Jill decides to leave 25% of her net profit in the company as retained earnings, she can claim BADR upon closing the company. This results in a total capital gain of £78,970: £61,266 from standard take-home and £17,704 from BADR.
That is a difference of £11,653 per year to Jack’s take-home or 15%. To earn an equivalent take-home while working inside IR35, Jack must charge a daily rate of £640, a 28% increase from what he currently earns.
Pension Contributions
As taxes are deducted at source for inside IR35 contractors, pension contributions are the only tax planning tool available. Maximising pension contributions reduces tax liability and increases total capital gained (this is different from take-home pay). This is also a popular strategy for outside IR35 contractors as well.
In our example above, if Jack decides to contribute 50% of his relevant earnings to his SIPP via salary sacrifice, he would have a total capital gain of £93,915: £40,293 from standard take-home and £53,712 from pension contributions. This is a substantial improvement over the £67,317 take-home achieved with no pension contributions.
If Jill were to do the same, she would have a total capital gain of £100,761: £43,261 from standard take-home and £57,500 from pension contributions. That is a difference of £6,846 per year to Jack’s take-home or 7%.
Summary
Every contractor’s working arrangements and earning profile differ, so identifying a single figure that can quantify the cost of being caught by IR35 is impossible. It can vary based on days worked, other sources of income, expenses, allowances, tax rates etc.
As such, there are some inherent limitations in the above calculations. For example, they do not consider the impact of allowable expenses outside IR35 contractors can offset against corporation tax. Pension contributions are simplified as well. While maximising pension contributions makes sense from a hypothetical tax reduction perspective, many contractors can’t afford to lock away such a high proportion of their income until they retire.
The same can be said about BADR. While it is a fantastic form of tax relief, it is only claimable once a company is wound down (i.e. closed). Until then, the money is stuck in the business and can’t be accessed. It also comes with the caveat that you can’t start another limited company in a similar industry for two years.
This article hopefully demonstrates that, while the difference between inside IR35 and outside IR35 take-home pay can be substantial, increasing your day rate to reflect the increased tax burden can go some way to reducing the deficit. Asking for a 20% to 30% uplift on your outside IR35 rate should result in similar take-home.
Although by no means a perfect resolution, working an inside IR35 contract is not the end of the world.