If you take on contractors – a freelance finance manager, an IT consultant, a marketing specialist working through their own limited company – you need to know whether they are inside or outside IR35. Get it wrong and HMRC can come after your business for years of unpaid tax, National Insurance and penalties, sometimes running into tens of thousands of pounds. Many SME owners hire contractors precisely to avoid the cost and commitment of employment, only to discover months later that the working arrangement looked so much like employment that HMRC disagrees. This article explains, in plain English, how to work out where a contractor sits and what it costs you either way.
What IR35 actually means for your business
IR35 – officially the off-payroll working rules – exists to stop people supplying their labour through a personal service company (PSC) purely to pay less tax and National Insurance than they would as an employee doing the same job. If HMRC decides a contractor is, in reality, working like an employee, the engagement is inside IR35. That means tax and employee National Insurance must be deducted at source, broadly as if the contractor were on your payroll, even though they invoice through their own company. If the working relationship is genuinely independent – the contractor controls how and when the work is done, takes on business risk, and could send a substitute – the engagement is outside IR35, and the contractor’s own company handles its own tax affairs.
Since April 2021, for medium and large private-sector businesses, the responsibility for deciding status has sat with the client, meaning you, rather than the contractor. Small companies, broadly those meeting at least two of: turnover under £15 million (previously £10.2 million), balance sheet under £7.5 million (previously £5.1 million), and fewer than 50 employees, are exempt from this client-responsibility rule. That exemption is worth checking every year, because growth can push you over the threshold without you noticing, shifting the risk squarely onto your business.
Inside or outside? The tests that actually matter
- Control – Does your business tell the contractor how, when and where to do the work, or do they decide that themselves? The more control you exert, the more the arrangement looks like employment.
- Substitution – Could the contractor send someone else to do the work instead of turning up personally? A genuine right of substitution, even if never used, is one of the strongest indicators of self-employment.
- Mutuality of obligation – Are you obliged to keep offering work, and is the contractor obliged to accept it? Employees typically have this; genuine contractors are engaged for a specific piece of work and nothing more.
- Financial risk and integration – Does the contractor invoice for a fixed project and fix their own mistakes at their own cost, or are they treated like any other member of staff, with a company email address, appraisals and holiday sign-off?
HMRC’s free Check Employment Status for Tax (CEST) tool is a reasonable starting point for straightforward cases, but it cannot weigh up nuance the way a tribunal can. For higher-value or higher-risk engagements, get a written status determination and keep the evidence that supports it.
Worked example: the real cost difference
Say your business engages Priya, a contract finance manager working through her own limited company, Priya Consulting Ltd, for 200 days over a year at a day rate of £500. That is £100,000 gross before any tax treatment. Below is how the cost and cash position differs depending on status.
| Outside IR35 (self-employed) | Inside IR35 (deemed employment) | |
|---|---|---|
| Gross invoice value | £100,000 | £100,000 |
| Income tax deducted at source | None – handled by Priya Consulting Ltd | Deducted via payroll before payment |
| Employee NI deducted | None | Deducted via payroll before payment |
| Employer’s NI (extra cost to your business) | None | Approx. £14,250 additional cost |
| Apprenticeship Levy (0.5%, if applicable) | None | Approx. £500 additional cost |
| Net amount received by contractor’s company | £100,000 (before her own tax) | Roughly £74,000 (after PAYE tax and NI) |
| Deemed direct payment (gross fee treated as employment income) | £100,000 |
| Employer’s National Insurance (15% above the £5,000 secondary threshold, simplified) | £14,250 |
| Apprenticeship Levy (0.5% of relevant pay bill, where applicable) | £500 |
| Total cost to your business for the same 200 days of work | £114,750 |
Notice that the £100,000 headline fee does not change – what changes is who pays the extra employer costs, and when. Outside IR35, Priya’s company invoices you £100,000 and deals with her own tax. Inside IR35, your business becomes responsible for calculating and paying employer’s National Insurance and the Apprenticeship Levy on top of the fee, and must deduct income tax and employee NI before paying the balance to Priya Consulting Ltd. That is an extra £14,750 in this example that many SME owners forget to budget for when a contractor’s status changes.
| Account | Dr | Cr |
|---|---|---|
| Contractor fees (P&L) | £100,000 | |
| PAYE income tax payable | £20,000 | |
| Employee NI payable | £6,000 | |
| Amounts due to Priya Consulting Ltd | £74,000 |
Recognises the £100,000 fee as an expense and sets up the payroll deductions required under the off-payroll working rules, before paying the net amount to the contractor’s company.
| Account | Dr | Cr |
|---|---|---|
| Employer’s NI expense (P&L) | £14,250 | |
| Apprenticeship Levy expense (P&L) | £500 | |
| Employer’s NI payable | £14,250 | |
| Apprenticeship Levy payable | £500 |
Records the additional employer costs that only arise because the engagement is treated as inside IR35 – these do not apply to a genuinely outside-IR35 contractor invoicing your business directly.
If you misclassify a contractor as outside IR35 and HMRC later disagrees, your business – not the contractor – is usually liable for the unpaid tax, employee NI, employer NI and penalties, potentially going back several years (though since April 2024, HMRC can offset taxes already paid by the contractor and their PSC against the PAYE liability to prevent double taxation). Six-figure retrospective liabilities have arisen in real tribunal cases where several contractors were affected at once. Blanket decisions such as ‘all our contractors are outside IR35’ are also risky; HMRC and tribunals expect a genuine, role-by-role assessment, not a one-size-fits-all policy.
How to make the call without guesswork
Work through the contract and the actual working practices together – they don’t always match. A contract can say ‘this is a contract for services’ while the reality on the ground is that the contractor turns up at 9am, follows your rota, uses your equipment and cannot send a substitute. Tribunals look at reality, not just the paperwork. Document your reasoning in a Status Determination Statement, give a copy to the contractor, and keep it on file. If the contractor disagrees, you must have a process for them to challenge it, and you must respond within 45 days.
What this means for your business
For SME owners and finance managers, IR35 status is not a one-off tick-box exercise – it is an ongoing cost and risk decision that belongs in your budgeting and contractor onboarding process, not just your tax return. Every time you engage a new contractor, or renew an existing one, the day rate you agreed six months ago might no longer reflect the true cost if the role has changed and quietly pushed the engagement inside IR35.
- Assess status before the engagement starts, not after HMRC asks – use the CEST tool as a first pass and keep a written Status Determination Statement for anything material.
- Budget for the extra 15% employer’s National Insurance (above the secondary threshold) and 0.5% Apprenticeship Levy if a role is inside IR35 – build it into the day rate negotiation, not as an afterthought.
- Review contracts against actual working practices at least once a year, especially where a contractor’s role has grown to look more like an employee’s – control, substitution and mutuality of obligation can shift over time.
- If your business falls under the medium or large company rules, keep evidence of your reasoning for each contractor – a genuine, role-specific assessment is your best defence if HMRC challenges the decision later.
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