What on Earth is IR35?

Keep hearing this bizarre little 4-character phrase buzzing around?
Let me help you to swat your IR35 confusion.

Note: I have done my best to make sure everything in this article is correct, but apologies if there are mistakes.
 

The basics of this IR35 thing

If you're a freelancer working through your own limited company, it's important that you understand what IR35 is. This is because it's a legislation that is designed to stop you from avoiding tax.

If you are self-employed, you pay less tax than if you are an employee. This means that it could be tempting to be self-employed when really you have a relationship with your client that is more like being their employee. IR35 legislation tests whether you are "genuinely self-employed" or not. If you are found to be more like an employee, you are "caught" by IR35.

"[IR35] applies where...if the services were provided under a contract directly between the client and the worker, the worker would be regarded for income tax purposes as an employee of the client."

Part 2, Chapter 8, 49, 1c. of Income Tax (Earnings and Pension) Act 2003

My translation: if you are self-employed but working in exactly the same way as you would if you were an employee of your client, you will need to pay more tax.

What does "genuinely self-employed" mean?

IR35 tests your employment "status" as to whether you are genuinely self-employed or not. However, there isn't a clear-cut way of saying whether or not you are truly self-employed or an employee:

"It must be emphasised that status is not a matter to be determined by running down some form of checklist... It is a matter of evaluating the overall picture that emerges from a detailed review of all the facts."

HMRC: Guide to determining status: relevant factors

There are a lot of things that the HMRC would look at if they were to investigate your employment status but it starts to get really complex and confusing so if you are unsure whether you are genuinely self-employed or not, I recommend using the HMRC Employment Status Tool.

TAX YOU PAY OUTSIDE VS INSIDE OF IR35

Before I explain the difference in tax rates, let me mention that many contractors pay themselves in two different ways:

That way they do not pay any employment tax. However, if they were to be caught by IR35 they would have to pay employment tax on all of their earnings, including dividends:

"If IR35 applies, all payments … are treated as your employment income and [you] must pay any tax and National Insurance contributions due. It ensures that you pay roughly the same amount of tax and National Insurance contributions as if you'd been directly employed by the client."

Gov.uk: IR35 Find out if it applies

Let's compare the two scenarios for tax year 2015-2016

We'll use an example where a contractor pays themselves a total personal income of £50,600 made up of:

 

Tax Applies to Rate % Genuinely self-employed
(Outside IR35)
Employee
(Inside IR35)
Corporation tax Company profits
(Revenue - expenses including employment income)
20% Paid N/A (No profit)
Employer N.I. Gross earnings 13.8% Not paid Paid
Employee N.I. (Lower bracket) Employment income between
£8,060 and £42,380 (approx)
12% Partially paid
(on approx £2,540)
Paid
Employee N.I. (Upper bracket) Employment income over
£42,380 (approx)
2% N/A (Bracket not reached) Paid
Personal Allowance Employment income between
£0 and £10,600
0% £0 £0
PAYE (Basic rate) Employment income between
£10,600 and £31,785
20% N/A (Bracket not reached) Paid
PAYE (Higher rate) Employment income between
£31,785 and £150,000
40% N/A (Bracket not reached) Paid
Dividend tax Dividends where total personal income (employment income plus dividends) is over £42,385 32.5% (effective 25%) Paid N/A (Dividends treated as employment income)
One other thing to remember:
Student loan repayments Total personal income (employment income plus dividends) over £17,335 9% Paid Paid

*Writing an article on expenses is currently on my to-do list!

Advice to help you stay outside IR35

Staying outside of IR35 really means ensuring you are genuinely self-employed. I have been recommended the following things:

Still confused?

IR35 is a confusing legislation because working out if you are genuinely self-employed or not isn't simple. If even after using the employment status tool you are still unsure, you can contact HMRC about IR35 here. Good luck!

See all of my thoughts