Inside IR35: What it means for contractors and your taxes

Published Friday 3 October 2025

Table of contents

• What is IR35?
• What does inside and outside IR35 mean?
• Inside IR35
• Outside IR35 meaning
• Financial impact of being inside IR35
• How to know if you are inside or outside IR35
• What to do if you're inside IR35
• Working through an umbrella company
• Navigating IR35: Tips for contractors and businesses
• Managing your finances with the right tools
• FAQs on inside IR35

Key takeaways

• Clients determines your IR35 status using three key tests: right of substitution (whether you must personally do the work), right of control (who decides how, when and where you work), and mutuality of obligations (whether there's ongoing obligation to provide and accept work).

• Prepare for reduced take-home pay when classified inside IR35, as your client will deduct Income Tax and National Insurance through PAYE just like a permanent employee, requiring you to adjust your rates accordingly.

• Review your Status Determination Statement (SDS) carefully when your client classifies you as inside IR35, as this document explains their reasoning and you have the right to challenge their decision if you disagree.

• Have clear documentation of your actual working practices and contract terms for each client relationship, since HMRC reviews both written agreements and real-world working arrangements when assessing IR35 compliance.

What is IR35?

IR35 is UK legislation that determines whether contractors should pay tax as employees or self-employed individuals. It prevents contractors from avoiding employee tax rates while doing the same work as permanent staff.

The tax gap problem: Employees pay Income Tax and National Insurance through PAYE, while limited company directors can choose how they pay themselves. This creates different tax bills for the same work.

HMRC's solution: IR35 ensures fair taxation by classifying some contractor arrangements as employment for tax purposes. Contractors outside IR35 continue paying tax through their limited company. Those inside IR35 pay tax like employees.

What does inside and outside IR35 mean?

IR35 status determines your tax treatment as either an employee or contractor for HMRC purposes.

Inside IR35 means you're classified as an employee for tax purposes. Your client deducts Income Tax and National Insurance through PAYE, just like permanent staff.

Outside IR35 means you remain self-employed for tax purposes. You can:

• Pay tax through your limited company
• Claim business expenses
• File company accounts and Self-Assessment returns
• Choose how to pay yourself (salary and dividends)

Make sure you get your IR35 status right to avoid penalties. If HMRC decides you should be classed as an employee, you may need to pay extra tax and National Insurance, plus interest.

If you do not take reasonable care when completing your tax returns and paying National Insurance, HMRC may charge a penalty.

The penalty is a percentage of any unpaid tax and National Insurance, following the rules in Schedule 24 of the Finance Act 2007.

Since April 2021, your client is responsible for deciding your IR35 status. The government updated the off-payroll working rules on 6 April 2021. Here is how HMRC assesses your status.

Inside IR35

Inside IR35 means HMRC treats your contractor role as employment for tax purposes. Your client becomes responsible for tax deductions, just like a regular employer.

Your client's responsibilities:

• Deduct Income Tax and National Insurance from your fees
• Determine your IR35 status using employment tests
• Provide a Status Determination Statement (SDS) explaining their decision

Getting help with inside IR35

• Professional advice: Accountants can help ensure IR35 compliance
• HMRC tool: Use the Check Employment Status for Tax (CEST) tool for guidance, which provides HMRC’s view of a worker’s employment status based on the information you provide
• Expert support: Speak with an advisor for complex situations

Outside IR35 meaning

If your contract is outside IR35, you pay tax and claim expenses through your company. Contracts where you are a contractor or freelancer, not an employee, are exempt from IR35 rules.

This means you can pay yourself a salary, take dividends, and handle your own tax reporting.

Financial impact of being inside IR35

When your contract is inside IR35, you're treated as an employee for tax purposes. This has a direct impact on your take-home pay.

Your client, or the agency paying you, will deduct Income Tax and National Insurance contributions directly from your fees through PAYE – just like they would for a permanent employee.

This means the amount you receive in your bank account will be lower than the gross value of your invoice.

Review your rates to account for these deductions and budget effectively from the start.

How to know if you are inside or outside IR35

IR35 status determination uses three employment tests to decide if you're working like an employee or genuine contractor. Professional advice from an accountant or bookkeeper can help ensure compliance.

The 3 IR35 tests include:

1. Right of substitution

• Key question: Must you personally do the work?
• Employee indicator: No right to send someone else
• Contractor indicator: Can substitute another qualified person

2. Right of control

• Key question: Who controls how, when and where you work?
• Employee indicator: Client sets hours, location and methods
• Contractor indicator: You decide how to deliver the results

3. Mutuality of obligations

• Key question: Is there ongoing obligation to provide and accept work?
• Employee indicator: Client must offer work, you must accept it
• Contractor indicator: No obligation beyond the specific contract

HMRC reviews your written contract and your working practices. If you work for a small business, you are responsible for deciding your own IR35 status.

The law is complex and each case is reviewed individually. In a recent case against Professional Game Match Officials Limited (PGMOL), the court debated whether companies must provide referees with work, which would make them employees.

Meeting some of these tests does not guarantee your IR35 status, but they are useful indicators.

If you’re unsure about your IR35 status, speak to an accounting professional.

What to do if you're inside IR35

If your client decides your contract is inside IR35, follow these steps. The fee-payer will handle tax deductions for you.

• Review your Status Determination Statement (SDS): Your client must give you this document explaining their decision. Make sure you understand their reasoning.
• Prepare for PAYE deductions: Your client or recruitment agency will handle the tax and National Insurance deductions. You'll be paid a net amount, similar to an employee.
• Talk to your accountant: An advisor can help you understand the full financial picture and ensure your records are straight for any work that falls outside IR35.

Working through an umbrella company

If you work inside IR35, you can use an umbrella company. The umbrella company acts as your employer.

The umbrella company signs a contract with your client or agency. You become their employee. They handle your payroll, deduct tax and National Insurance, and pay you a salary. This makes your admin easier and keeps you tax-compliant.

Navigating IR35: Tips for contractors and businesses

Clear documentation helps determine and prove your IR35 status. Each client contract may have a different status, so review them individually.

For contractors:

• Contract clarity: Ensure working agreements clearly reflect your true working relationship
• Record keeping: Document your actual working practices as evidence for HMRC
• Regular reviews: Assess each client relationship separately

• Status determination: You're responsible for deciding contractors' IR35 status
• Tax obligations: Deduct Income Tax and National Insurance if they're inside IR35
• Documentation: Provide Status Determination Statements explaining decisions

Getting professional help: HMRC reviews each case individually, making professional guidance valuable. Find trusted advisors in our advisor directory.

For more help running your business, see the Xero small business guides.

Managing your finances with the right tools

Whether you're working inside or outside IR35, staying on top of your finances is key to running a successful business. Clear, organised records make it easier to manage your cash flow, plan for tax, and work with your accountant.

Xero accounting software helps you see your financial position in real time. You can track income from different contracts, manage business expenses, and see your profitability. This puts you in control and helps you make confident decisions for your business.

Try Xero accounting software for free to see how easy it can be.

FAQs on inside IR35

Find answers to common questions about inside IR35 below.

Is it better to be inside IR35?

Most contractors prefer to work outside IR35 for higher take-home pay. Inside IR35 can be simpler, as your client handles tax deductions. Make sure your status is correct and you follow the rules.

How is my take-home pay calculated inside IR35?

Your take-home pay is your daily or project rate, minus income tax and National Insurance. Your client or the fee-payer makes these deductions. Speak to an accountant for a precise calculation.

What is a Status Determination Statement (SDS)?

A Status Determination Statement (SDS) is a document your client gives you. It states if your contract is inside or outside IR35 and explains their reasons. You can challenge the decision if you disagree.