What is IR35?
IR35 is a UK tax rule designed to stop “disguised employment”. It applies when contractors work like employees but operate through a personal service company (PSC) to gain tax advantages.
Also called the off-payroll working rules, IR35 determines whether a contractor should pay tax as an employee. Businesses hiring contractors must assess and manage IR35 status correctly.
Who does IR35 apply to?
IR35 applies to contractors who provide services through a personal service company (PSC) or another intermediary, instead of being hired as direct employees.
It commonly affects:
- Freelancers working on long-term contracts
The rules also affect the businesses hiring them.
For contractors
IR35 applies if:
- You work through a limited company
- You personally provide the services
- Your working arrangement resembles employment
For businesses
Medium and large organisations are usually responsible for making the IR35 determination and assessing whether a contractor falls inside or outside IR35.
Small businesses are generally exempt, meaning the contractor remains responsible for their own IR35 status assessment. According to HMRC, responsibility depends largely on the size of the client organisation under the off-payroll working rules.
Interestingly, IPSE’s 2025 IR35 research found that 27% of contractor engagements involved businesses exempt from the off-payroll rules, often because the client qualified as a small business.
Inside IR35 vs outside IR35
If a contract falls inside IR35, HMRC sees the contractor as working much like an employee. If it falls outside IR35, the contractor is considered genuinely self-employed.
This affects tax, National Insurance, contractor pay, and employer responsibilities under the off-payroll working rules.
| Inside IR35 |
Outside IR35 |
| Employee-style tax deductions |
Paid through own limited company |
| PAYE and National Insurance apply |
Greater tax flexibility |
| Lower take-home pay |
Usually higher take-home pay |
| More control from the client |
More independence and control |
| Higher compliance responsibilities for businesses |
Lower IR35 risk for businesses |
How IR35 status is determined
IR35 status is determined by looking at the real working relationship between the contractor and the business, not just the contract wording.
HMRC usually considers factors such as:
- Whether a substitute can be sent
- Working hours and exclusivity
- How integrated the contractor is within the business
If the arrangement looks more like employment, the contract may fall inside IR35. Businesses often use HMRC’s CEST tool alongside professional advice to support IR35 compliance decisions.
Why IR35 matters for businesses
- Incorrect IR35 assessments can lead to tax bills, penalties, and HMRC investigations.
- Businesses may become responsible for unpaid PAYE tax and National Insurance.
- IR35 compliance affects how contractors are hired and managed.
- Poorly written contracts can increase off-payroll working risks.
- Some contractors avoid inside IR35 roles because of lower take-home pay.
- Reviewing working arrangements regularly helps reduce compliance issues.
- Understanding IR35 rules helps UK SMEs hire contractors more confidently and avoid expensive mistakes later.
Common signs a contractor may fall inside IR35
A contractor may fall inside IR35 if they work similarly to a permanent employee rather than an independent business.
Common signs include:
- Close supervision from managers
- No right to send a substitute
- Long-term exclusive work for one client
- Using company equipment regularly
- Receiving employee-style benefits
- Being heavily integrated into the business team
Example of IR35 in a real business scenario
A growing software company in Bristol brings in a contractor through their limited company to help rebuild its customer portal after a rushed product launch.
The project starts as a short-term contract. A few months later, the contractor is still there full-time. They now:
- Work the same hours as employees
- Attend internal team meetings every day
- Report directly to the operations manager
- Need approval before taking time off
The contractor cannot send a substitute and no longer works with other clients during the project. Even though payments go through a personal service company (PSC), the day-to-day arrangement looks much more like employment. That could place the contract inside IR35 under the off-payroll working rules.
FAQs
1. Who decides the IR35 status?
For medium and large businesses, the client usually decides the contractor’s IR35 status. Small businesses are generally exempt, meaning the contractor normally remains responsible for assessing their own status.
2. What happens if you fail IR35?
If a contractor falls inside IR35 incorrectly, HMRC may demand unpaid tax, National Insurance, interest, and penalties. Businesses can also face investigations and additional compliance checks.
3. Do small businesses need to worry about IR35?
Yes, although small businesses are usually exempt from making formal IR35 determinations. Contractors working with small companies still need to assess their own IR35 status correctly.
4. What is a Personal Service Company (PSC)?
A personal service company (PSC) is a limited company used by contractors to provide services to clients. Many freelancers and consultants operate through PSCs for tax and business purposes.
5. Is IR35 only for IT contractors?
No. Although common in IT, IR35 can affect contractors across marketing, engineering, finance, construction, design, healthcare, and many other industries using freelance or contract workers.
