IR35 is a tax legislation that is enforced in the UK. To explain IR35, the aim of the legislation is to find any ‘disguised employees’ (contractors who have a significant ‘employment relationship’ with their client) and make sure that they are paying the right amount of social contribution and tax payment. Contractors who have this relationship (defined by a set of IR35 rules) with their client are classed as being ‘inside IR35’ which results in a payment of significantly more tax.
IR35 is becoming more talked about in recent months due to the proposed IR35 changes that are set to occur on April 2020. As part of this reform, it will be down to the end-client/employer to determine the tax status of the contractor which could change the amount of tax that they pay. This can have significant financial implications for the contractor and it’s something that they should be prepared for.
Enter your details into our IR35 calculator to determine the impact that IR35 could have on your income:
The financial effects of IR35
One of the main concerns for IR35 contractors and end-clients is the financial effect that IR35 can have. Unfortunately, an IR35 investigation could find the contractor ‘inside IR35’ when they were claiming to be ‘outside’ which can have negative implications. So, how does it affect these two parties?
Impact on contractors
Contractors generally work on a project-by-project basis. Unlike a permanent member of staff, this means that their financial situation is not always secure. It could be seasonal or temporary work that they find themselves in and the next job is not always guaranteed. Due to this instability, the financial impact that IR35 can cause is significant and can even be life-changing. If they have to pay more tax on their earnings, this can heavily sway the balance sheet and result in some losses for the company. As a contractor, it’s best to stay well-informed on how to ensure that you are ‘outside IR35’.
When a freelancer or contractor is ‘outside IR35’, they operate in the same way as a limited company. This structure means that the contractor legally pays themselves a small salary and pays the rest of his income from company dividends (a sum of money, out of the company’s profits, which is paid to shareholders). What about the tax that they pay? If a contractor is ‘outside IR35’ they still pay corporation tax on their profits, but it is significantly lower than what they would pay if they were found to be ‘inside IR35’.
If the tax status of a contractor is ‘inside IR35’, their tax structure is similar to that of a permanent employee of the end client. In this situation, tax payments can only be minimized with the use of expenses benefits. If an employee claims to be ‘outside IR35’ but is later found to be ‘inside’, although they will face higher tax payments, they will not receive any employment benefits.
It’s hard to imagine how you could be affected without any comparison to your wage. So, in monetary terms, how much could a contractor be losing out on? Since the legislation was first introduced in 2000, there have been some studies carried out to determine the impact of a contractor being caught by IR35. They discovered that a typical contractor who earns £300 per day would be £10,000 worse off on an annual basis if he was caught by IR35.
Impact on end-clients and employers
The reform in 2020 will see tax liability sitting with umbrella companies, end-clients or employers in the private sector. This is already the case in the public sector following changes to the legislation in 2017. This means that the employer is now liable for determining whether a contractor is ‘inside IR35’ or ‘outside’. When it comes to the financial implications, the company can be penalised for breaking the rules. In fact, HMRC predicts that the cost of non-compliance in the private sector will increase from £700 million in 2017/18 to an astounding £1.2 billion in 2022/23.
How does the IR35 calculator work?
The calculator works by estimating your tax structure as an employee within IR35 and an employee outside of IR35. With this information, your finances can be assessed, and you can find out exactly how much more you would be paying if you were caught out by IR35. It’s important to be aware of this information and take the steps necessary to avoid operating ‘inside IR35’.
The IR35 calculator considers a range of information when calculating the impact of the legislation on your take-home pay. First of all, you enter your rate of pay which determines the extent of your tax burden. For example, if a contractor earns £20 per hour, the difference in monthly take-home pay for inside and outside of IR35 is a decrease of 24% and a tax increase of 35%. However, for a contractor that earns only £30 more per hour, at £50 per hour, the difference between inside and outside IR35 is a tax increase of 35% and a decrease in monthly take-home pay of 21%.
Other factors that the calculator considers are:
- Your rate type (hourly or daily)
- Your current IR35 status (outside or inside)
- The number of hours that you work per week
- The number of days that you work per week
- The number of weeks that you work per year
- Your annual expenses
- Your gross salary – drawn as Director
- Annual pension contributions
- Any other annual income
- The percentage that you receive when you split the dividend
- Your personal tax code
- The tax year that you’re enquiring about
When should you use the IR35 calculator?
The IR35 calculator has been created to help contractors determine how much more tax they could be paying if they were found to be ‘inside IR35’. We know that it is a significant amount, but it does differ on an individual basis and it’s worth finding out how it could impact you if you were caught claiming the wrong tax status.
When you’re considering a new contract
You should always review a new contract from an end-client carefully before signing and accepting. Not only is this for hidden clauses or agreements that you might not have discussed, but it may put you ‘inside IR35’. For example, a clause that states your set working patterns could be seen as an ‘employment relationship’ by HMRC that would sit you ‘inside IR35’. As of April 2020, it will be down to the employer to determine your tax status and, although you can appeal, you may still be penalised. Before you accept a new contract or consider accepting one that could place you ‘inside IR35’ you should use the calculator to determine any potential losses.
If you’re under IR35 investigation
An IR35 investigation can be launched by HMRC at any time. It can occur for contractors in the public or private sector and can result in workers who claim to be ‘outside’ or ‘inside’ IR35 being investigated without warning. If you find yourself under investigation and suspect you may be caught out, it’s worth using the calculator. You can use the calculator to find out how much you may owe from current contracts if you are claiming the wrong status, but it’s also worth bearing in mind that HMRC can investigate contracts that go as far back as six years. If you suspect that any of your previous contracts may have been under the wrong tax bracket, you should calculate your potential owed payments to prepare for a repayment notice.
Avoid losing out financially to IR35
As we’ve discussed, there are many financial implications for contractors when it comes to IR35. Of course, you can use the calculator to estimate your potential higher payments or owed repayments, but the best strategy is to avoid operating within IR35 by successfully passing the IR35 test. But, how can this be done?
Reviewing your contract
First of all, paying attention to the IR35 rules, review your contract carefully to ensure it passes IR35. The general rule of thumb that HMRC follows is that your contract should show that the end-client is engaging with you for your services and not you as an individual. If your contract implies an agreement outside of this, you could land yourself in trouble.
Following the 2017 IR35 reform and the proposed 2020 changes, the tax liability of the contractor lies with the end-client (or an intermediary depending on the supply chain). It is no longer down to the contractor themselves to decide whether they are IR35 compliant or non-compliant. Learning from the 2017 changes, where many employers incorrectly labelled their contractors as ‘inside IR35’ to avoid taking any risks, the 2020 reform proposes that contractors will have the opportunity to disagree with any decision made. If you find that your client has labelled you as ‘inside IR35’ but you strongly believe you are not, you should use your rights to appeal the decision and seek legal advice. Again, it could be worth using the IR35 calculator to determine what you may have to pay out if you lose this appeal.
Taking out IR35 insurance
IR35 insurance can protect you in a range of situations to do with this legislation. For example, if you do find yourself at the centre of an investigation, insurance can give you financial security in the case of an owed payment and representation. This means that you’d be provided with an expert to help you fight your case in a law court. Taking out insurance like this can help decrease your chances of an unexpected payout that could affect your finances.
Using an umbrella company
Umbrella companies are employers that act as a mediator between a contractor, the end-client and often a recruitment agency. They are able to manage your payroll, National Insurance and tax repayments to avoid any confusion when it comes to the IR35 legislation. This is an option that many contractors choose to avoid unwelcome penalties in the case of incorrect tax status.
As we can see, the calculator is a useful tool to measure the difference in the income you’ll receive depending on your IR35 status. It’s worth remembering that IR35 affects the private sector and reform for this sector is due in April 2020. IR35 changes in the public sector occurred in 2017 which means that contractors across all industries are now affected. Bear in mind that one way to remove the burden of IR35 for contractors is with an umbrella company. You can compare umbrella companies with the form on this page to find a company to suit your contractor needs.
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