What is IR35, and What Does It Mean for Your Business? 

The UK has introduced legislation known as IR35 to address gaps in tax compliance and clarify the legal standing of contractors versus employees. If your business operates in the UK or you work with UK-based contractors, it’s vital to understand how these rules could impact your operations. 

IR35 significantly affects both businesses and temporary workers across the UK. Incorrectly classifying a contractor or failing to comply with IR35 regulations can result in costly penalties. For companies unfamiliar with the UK’s tax system, understanding these rules is essential. 

At Accounting People, we know navigating compliance can be complex. That’s why this guide is designed to break IR35 down, clearly explaining what the law covers, who it applies to, and how it affects contractor arrangements. Whether you’re a business owner, HR manager, or finance director, this resource will help you make confident, informed decisions when hiring UK-based talent. 

What Is IR35?

IR35, officially known as Inland Revenue 35 or the “Intermediaries Legislation” is a set of tax rules that apply to off payroll working arrangements in the UK. It’s designed to determine whether a contractor is genuinely self-employed or, for tax purposes, should be considered an employee. 

The legislation applies to individuals who provide services via an intermediary, such as a personal service company (PSC) or limited company (LC). The intention is to ensure off-payroll contractors pay similar income tax and National Insurance contributions (NICs) as directly employed workers. 

To determine IR35 status, HMRC looks at factors such as control (who dictates the work), substitution (can the contractor send someone else?), and mutuality of obligation (what the client is required to provide). If these mirror an employment relationship, then the contractor may fall “inside IR35” meaning they are effectively employees in the eyes of the law. 

IR35 was introduced to prevent “disguised employment,” where individuals operated as contractors through their own limited companies to reduce their tax liability despite working much like permanent employees. These loopholes allowed many to pay lower taxes and avoid NICs. 

In April 2021, the UK extended IR35 rules to the private sector. This shifted responsibility for determining IR35 status from the contractor to the business hiring them. As a result, many contractors moved to inside-IR35 arrangements, with around 35% leaving self-employment and 80% experiencing reduced earnings under the new rules. 

Who Is Affected by IR35? 

IR35 legislation applies to both contractors and the businesses that engage with them. 

Contractors in the UK have historically paid less tax by setting up a limited company and accepting client payments through it. However, HMRC believes many of these individuals were operating in a way that resembled employment without paying the associated tax. If a contractor would be classified as an employee, were it not for their limited company, they are now treated as a “deemed employee” under IR35 and must pay income tax and National Insurance accordingly. 

Medium and large businesses in the private sector as well as all public sector organisations are responsible for determining the IR35 status of contractors they work with. However, small businesses are currently exempt. To qualify as a small business, the company must meet at least two of the following criteria: 

• Annual turnover under £10.1 million 

• Gross assets below £5.1 million 

• Fewer than 50 employees 

Businesses that do not meet this exemption are required to carry out IR35 assessments for any off-payroll workers they engage. 

Does IR35 Apply to Non-UK Companies? 

Yes, in some situations, IR35 rules can apply to businesses outside the UK. 

If a contractor is a UK tax resident and provides services to a medium or large company, even one based outside the UK that business may be responsible for determining the contractor’s IR35 status. This applies even if the contractor works remotely from the UK and the client is overseas. 

There are additional layers to consider where reciprocal agreements (RAs) exist between the UK and other countries. These agreements can affect which country’s social security rules apply. For example, under the RA between the UK and the United States, workers may be exempt from UK National Insurance contributions for up to five years if they remain under the US system. 

However, if a non-UK business has a presence in the UK such as a branch, office, or UK-based subsidiary, it is far more likely to fall under IR35 requirements when engaging with UK contractors. 

The safest route for international businesses is to treat each contractor on a case-by-case basis. Blanket assessments should be avoided. 

Is There IR35 in the U.S? 

No IR35 is specific to UK tax legislation and does not apply in the United States. However, that doesn’t mean U.S-based companies are automatically exempt from its rules when engaging UK-based contractors. 

If a U.S business has a UK presence such as a registered office or branch and engages contractors based in the UK, it may still be required to determine the IR35 status of those workers. The determining factor is not where the company is headquartered but whether it has a footprint in the UK, and whether the contractor is a UK tax resident. 

For example, if a UK-based web developer contracts with a major U.S company like Microsoft, and Microsoft has a UK presence, it must assess whether the contractor falls inside or outside of IR35. 

It’s also important to note that the US has its own classification systems for workers: W2 employees and 1099 independent contractors. These classifications, governed by IRS rules and state labour laws, determine tax obligations, benefits, and employment rights within the US but are entirely separate from IR35. 

What Does It Mean to Be Subject to IR35 Legislation? 

When a contractor falls within the scope of IR35, known as being “inside IR35,” they are treated as an employee for tax purposes. This means both the contractor and the hiring business have additional tax responsibilities, including income tax and National Insurance contributions. 

Previously, HMRC (the UK’s tax authority) was responsible for identifying non-compliant contractors. However, since the IR35 reform for the private sector in April 2021, that responsibility has shifted to the hiring company unless the company is considered a “small business” (based on the criteria mentioned earlier). 

There are two classifications under IR35: 

Outside IR35 

If a contractor is genuinely self-employed and operates independently with their own financial risk, multiple clients, and control over their work, they are considered “outside IR35”. In this case: 

• The contractor is responsible for managing their own tax affairs 

• They can continue using their limited company to receive income and claim allowable expenses 

• They can split income between salary and dividends 

It’s still the client’s responsibility to make this status determination if they’re a medium or large company. 

Inside IR35 

If a contractor is classed as “inside IR35”, then for tax purposes, they are treated similarly to a full-time employee. In this case: 

• The client (or agency) must deduct income tax and employee/employer National Insurance before paying the contractor 

• The contractor may see reduced take-home pay 

• They are not entitled to employee benefits such as paid holiday or sick leave 

This classification can lead to additional costs for the hiring company and reduced net earnings for the contractor. 

Does a Contractor Inside IR35 Become a Full Employee? 

No, even if a contractor is determined to be “inside IR35,” they do not automatically become a full employee in terms of employment rights or benefits. While they may be taxed as an employee and their income may be subject to PAYE deductions and National Insurance contributions, they are not entitled to employment benefits such as sick pay and paid time off. 

The IR35 rules are strictly about tax and National Insurance. They do not grant employment status or protections under UK employment law. This means a contractor can face the tax burden of being an employee without receiving any of the associated benefits. 

For businesses, this distinction is important. Just because you’re paying taxes on behalf of a contractor does not mean they’re legally considered part of your workforce in other respects unless a separate employment contract exists.

What If a Contractor Is Termed a ‘Deemed Employee’? 

A “deemed employee” is a contractor who, under IR35 rules, is found to be working in a way that reflects employment rather than genuine self-employment despite being engaged through a limited company or personal service company. 

If HMRC determines that a contractor should have been classified as inside IR35 but was incorrectly treated as outside, both the contractor and the business can face serious consequences: 

• Contractors and Businesses may be required to pay backdated income tax and National Insurance contributions 

• Interest will likely be charged on the unpaid amounts 

• Penalties may also be applied, depending on whether HMRC believes the misclassification was careless or deliberate 

How Does an SDS Help Companies Comply with IR35 Rules? 

An SDS or Status Determination Statement is a key part of IR35 compliance for medium and large businesses engaging contractors. It is a formal document that sets out: 

• The contractor’s IR35 status (whether they fall inside or outside IR35) 

• The reasons behind that decision 

• Evidence showing that the company took reasonable care in making the determination 

This statement must be shared not only with the contractor but also with any agency involved in the supply chain. It provides transparency and ensures all parties are aware of the contractor’s tax position. 

Importantly, if the contractor’s working arrangements change during the engagement such as a shift in responsibilities or scope of work, the SDS must be updated to reflect those changes. A fresh assessment may be required, followed by a new SDS. 

Failing to produce or update an SDS properly can result in the company being held liable for PAYE tax and National Insurance, not the contractor. 

In fact, HMRC can investigate up to six years of tax records, so the financial impact can be substantial especially if the contractor has operated outside IR35 for a long period but was found to be working as a permanent employee. 

Businesses that engaged by the contractor can also be held liable for unpaid employer NICs and could face penalties for non-compliance. While HMRC offered leniency for honest mistakes when the rules first changed in 2021, penalties still apply in cases where reasonable care wasn’t taken or where deliberate misclassification is found. 

Additionally, companies that are non-compliant could face reputational damage, especially if they’re named in HMRC’s public compliance reports.

What Happens If the Contractor Disagrees with the SDS the Company Creates? 

If a contractor disputes the outcome of the Status Determination Statement (SDS), they have the right to challenge the decision. This must be done within 45 days of receiving the SDS either in writing or verbally. 

Once the dispute is raised, the client (i.e. the company engaging with the contractor) must respond within 45 days. During this time, the company is required to: 

1. Reconsider the determination, taking into account the contractor’s evidence or arguments 

2. Decide whether to uphold or overturn the original status 

3. Communicate the decision in writing to the contractor 

4. If the status is changed, issue a new SDS

If the company fails to respond within 45 days, it automatically becomes responsible for the contractor’s PAYE tax and National Insurance contributions regardless of the contractor’s actual status. 

This process ensures fairness and gives contractors an opportunity to correct misjudged IR35 classifications. However, it also puts a clear responsibility on companies to deal with disputes professionally, transparently, and on time.

What Is ‘Reasonable Care’ in the Eyes of IR35? 

Under IR35 rules, businesses are required to take reasonable care when determining a contractor’s status. This means making a genuine, evidence-based effort to assess whether a contractor falls inside or outside IR35, not rushing or applying blanket decisions. 

So, what does HMRC expect? 

To demonstrate reasonable care, companies should collect and review the following: 

• Does the contractor have other clients? A contractor working with multiple businesses is more likely to be genuinely self-employed. 

• Does the contractor take on financial risk? For example, buying their own insurance, using their own tools, or covering the cost of mistakes. 

• Is the contractor operating through a genuine business? Evidence like a website, registered limited company, and their own client contracts can help prove this. 

• How different are the contractor’s working practices compared to employees? If contractors are expected to follow employee rules, work fixed hours, and report to a manager, it suggests an employment relationship. 

All of this information should be recorded and retained to show HMRC that the company followed a fair process. Importantly, blanket assessments (e.g., labelling all contractors inside IR35 by default) do not count as reasonable care and may lead to non-compliance penalties. 

What is the CEST (Check Employment Status for Tax)? 

CEST, or Check Employment Status for Tax, is an online tool developed by HMRC to help businesses and contractors determine a worker’s employment status for tax purposes including whether a contractor falls inside or outside IR35. 

The tool works by asking a series of questions about the working relationship between the contractor and the client. These questions cover areas such as: 

• Level of control (e.g., who decides what work is done and how) 

• Substitution rights (e.g., can the contractor send someone else to do the job?) 

• Financial risk (e.g., who pays for mistakes or project overruns?) 

• Mutuality of obligation (e.g., is the company obliged to offer work, and is the contractor obliged to accept it?) 

The answers are used to give a determination, and this can serve as evidence that the company has taken reasonable care when assessing a contractor’s IR35 status. 

CEST has had criticism in the past for being too limited in scope, especially in complex cases. However, it remains HMRC’s official tool and using it can demonstrate compliance with due diligence expectations provided it’s used carefully and supported with additional evidence where needed. 

You can access the CEST tool directly on the UK government website. 

How to Pay Contractors and Stay Compliant in the UK After IR35 

IR35 shouldn’t discourage companies from working with UK-based contractors, but it does mean they need to pay closer attention to how they engage and pay them. 

With its highly skilled workforce, the UK remains an attractive destination for hiring independent professionals. The IR35 legislation is not meant to make things harder it simply aims to ensure that contractors and businesses are paying the correct taxes based on how the working relationship is structured.

Here’s how to stay compliant post-IR35: 

• Assess every contractor relationship individually. Avoid blanket determinations and instead conduct a proper IR35 status check with supporting documentation. 

• Create and issue an SDS (Status Determination Statement) for each contractor. This shows that you’ve applied reasonable care and clarifies whether the worker falls inside or outside the IR35. 

• Use the CEST tool and other reasonable evidence to back up your decision. 

• Keep detailed records of your assessments and any changes in contractor relationships. 

• If your contractor is inside IR35, ensure tax and NICs are paid through payroll (or an umbrella company if applicable). 

If you’re a non-UK company engaging with UK-based contractors, ensure you understand your obligations particularly if you have a UK presence such as a branch, office, or legal entity. 

The Easy Way to Stay Compliant with IR35 

Understanding IR35 isn’t just a box-ticking exercise, it’s essential for UK companies and global businesses working with contractors here. Whether you’re hiring locally or managing remote workers, your responsibilities under IR35 will vary depending on the contractor’s status, the nature of the work, and your company’s size and location. 

To stay compliant, you’ll need to assess each contractor’s relationship carefully considering things like who controls the work, whether the contractor can send a substitute, and if there’s a mutual obligation between both parties. These seemingly small details play a big role in how HMRC views the working arrangement. 

The good news? You don’t have to do this alone. 

With the right guidance and tools in place, businesses can confidently manage their contractor relationships without the risk of misclassification.  

At Accounting People, we help businesses navigate the complexities of contractor compliance, taxation, and payroll across the UK so you can focus on running your business with peace of mind.

Need help staying IR35 compliant? 

Book your free consultation with Accounting People today and let’s make IR35 one less thing to worry about.