IR35 Explained: What Contractors Need to Know in 2025-26
IR35 can cost contractors tens of thousands of pounds per year. Understanding the rules — and how to structure your engagement correctly — is essential.
What Is IR35?
IR35 — formally known as the "off-payroll working rules" — is tax legislation that tests whether a contractor working through a limited company (a "Personal Service Company" or PSC) should actually be treated as an employee for tax purposes.
The rules were introduced in 2000 because HMRC noticed that many workers who functionally operated as employees were routing their income through limited companies to pay dividends instead of salary, avoiding significant amounts of income tax and National Insurance. IR35 is HMRC's mechanism to stop this — determining who is a genuine contractor and who is a "disguised employee."
The consequences of the determination are significant:
- Inside IR35: You are treated as an employee for tax. PAYE income tax and National Insurance (both employee and employer contributions) are deducted from your contract value before you receive payment. You cannot use the limited company dividend structure.
- Outside IR35: You are treated as a genuine contractor. Your company receives the full contract value. You can take a combination of salary and dividends, significantly reducing your overall tax burden.
The Three Tests for IR35 Status
HMRC uses established employment law case tests to assess IR35 status. Three factors are most important:
1. Control
Does the end client control how, when and where you carry out your work? Employees are subject to direction and oversight by their employer. A genuine contractor has discretion over how they deliver the work — the client specifies the outcome, not the method. If you are required to follow the client's processes, use their systems, work specific hours, and report to a line manager, this points toward "inside IR35."
2. Substitution
Can you send a substitute to do the work in your place? Employees are hired personally — you cannot send someone else to do your job. A genuine contractor should have the right (even if rarely exercised) to provide a suitably qualified substitute without requiring the client's approval. If your contract says you personally must perform the work, this points toward employment status.
3. Mutuality of Obligation (MOO)
Is the client obliged to offer you work, and are you obliged to accept it? Employees have ongoing obligations — the employer provides work, the employee performs it. Genuine contractors work on a project basis with no expectation of continued engagement once the project ends. If you are expected to be continuously available and take on whatever the client needs, MOO exists and points toward "inside IR35."
Other factors considered include whether you provide your own equipment, take financial risk, work for multiple clients, and whether there is an "integration" into the client's organisation (having a business card, email address, attending all-hands meetings, etc.).
Who Determines Your Status?
The off-payroll working reforms changed who is responsible for status determination:
- Public sector engagements (since April 2017): The end client always determines status.
- Medium/large private sector clients (since April 2021): The end client determines status and must issue a Status Determination Statement (SDS). If the SDS is wrong, the client (not you) bears the tax liability.
- Small company clients: You (the contractor through your PSC) determine your own status.
A company is "small" for 2025-26 if it meets at least two of: turnover below £10.2m, balance sheet below £5.1m, fewer than 50 employees.
The Real Financial Cost: Inside vs Outside IR35
The difference in take-home pay between inside and outside IR35 is substantial. Here is a worked example for a contractor on a £500/day rate, working 220 days per year (gross contract value: £110,000).
Outside IR35 (Optimal Salary + Dividend Structure):
- Company receives: £110,000
- Director salary (£12,570): no IT, no NI
- Employer NI on salary above £9,100: ~£521
- Accountant + expenses (est.): ~£3,000
- Company profit after salary/expenses: ~£93,909
- Corporation Tax at 19% (on profits up to £50k) / 25% (above £250k) — approximately 19% here: ~£17,843
- Post-CT profit as dividends: ~£76,066
- Dividend tax: £500 allowance + ~£32,830 at 8.75% + ~£43,236 at 33.75% = ~£2,873 + ~£14,592 = ~£17,465
- Total take-home: £12,570 (salary) + £76,066 (dividends) − £17,465 (div tax) = approximately £71,171/year (~£323/day)
Inside IR35 (PAYE on Full Contract Value):
Inside IR35, your "deemed salary" is the contract value minus 5% deemed expenses allowance: £110,000 × 95% = £104,500.
- Income tax: ~£31,432 (on £104,500)
- Employee NI: ~£3,776 (8% on £37,700 + 2% on £54,230)
- Employer NI: (£104,500 − £5,000) × 15% = £14,925 (deducted from contract value before you receive it)
- Net received by company after employer NI: £110,000 − £14,925 = £95,075
- After employee IT and NI: £95,075 − £31,432 − £3,776 = approximately £59,867/year (~£272/day)
The difference: approximately £11,304 per year — a significant hit for doing the same work at the same day rate.
Day Rate Comparison: Inside vs Outside at Different Rates
| Day Rate | Annual (220 days) | Outside IR35 Net | Inside IR35 Net | Annual Difference |
|---|---|---|---|---|
| £300/day | £66,000 | ~£47,200 | ~£38,100 | ~£9,100 |
| £500/day | £110,000 | ~£71,200 | ~£59,900 | ~£11,300 |
| £700/day | £154,000 | ~£91,600 | ~£79,400 | ~£12,200 |
| £1,000/day | £220,000 | ~£118,500 | ~£106,700 | ~£11,800 |
Note: these are approximate figures based on the salary+dividend structure. Individual results will vary depending on company expenses, pension contributions, and other factors. Consult an accountant for your specific situation.
How to Protect Outside-IR35 Status
- Contract wording: Ensure your contract includes genuine substitution clauses, specifies deliverables rather than time, and avoids language typical of employment (e.g., "line manager", "annual leave").
- Working practices: Your actual working arrangements must reflect the contract. Using a client-issued laptop, attending mandatory company meetings, and having the client's email address all point toward employment.
- Multiple clients: Working for more than one client simultaneously is strong evidence of genuine self-employment.
- CEST tool: HMRC's Check Employment Status for Tax (CEST) tool can give an indication of status, though it is not legally binding. Specialist IR35 reviewers can provide a more robust opinion that can serve as insurance evidence.
- IR35 insurance: Consider professional indemnity insurance that covers IR35 investigations and any resulting tax liability.
Frequently Asked Questions
What is IR35?
IR35 (off-payroll working rules) is legislation that tests whether a contractor working through a limited company is a genuine contractor or a "disguised employee." Inside IR35 means paying PAYE and NI on your contract value. Outside IR35 allows the tax-efficient salary-plus-dividends structure.
How is IR35 status determined?
The three key tests are Control (does the client dictate how you work?), Substitution (can you send a replacement?), and Mutuality of Obligation (are both parties obliged to continue the engagement?). An independent contractor should score well on all three.
Who determines IR35 status in 2025-26?
For medium and large private sector clients, and all public sector clients, the end client determines status and issues a Status Determination Statement. For small company clients, the contractor (through their PSC) makes their own status determination.