Inside IR35: What it means for contractors and your taxes
IR35 rules determine whether you're genuinely self employed or should be taxed as an employee.
Written by Jotika Teli—Certified Public Accountant with 24 years of experience. Read Jotika's full bio
Published Friday 14 November 2025
Table of contents
Key takeaways
• Apply the three IR35 tests to determine your status by evaluating your right of substitution, the client's level of control over your work, and whether there's ongoing mutual obligation between you and the client.
• Recognise that medium and large private sector clients must determine your IR35 status and provide a Status Determination Statement, while you remain responsible for the determination if working with small businesses.
• Understand that working inside IR35 means your client deducts Income Tax and National Insurance like a regular employee, typically resulting in lower take-home pay but simplified tax administration.
• Maintain clear documentation of your actual working practices and contract terms for each client relationship, as HMRC reviews cases individually and your status may differ between contracts.
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 directors of the UK's more than 5.4 million limited companies 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)
If HMRC decides you should be classed as an employee instead of a contractor, you must pay the tax and National Insurance due, plus any interest.
If you do not take reasonable care when completing tax returns and paying National Insurance, HMRC may charge you a penalty. HMRC calculates this penalty as a percentage of any unpaid tax and National Insurance.
Since April 2021, your client must decide your IR35 status if they are a medium or large business. Private sector clients must determine if you are an employee or a contractor for tax purposes.
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
- Expert support:Speak with an advisor for complex situations
Outside IR35 meaning
If your contract with a client falls outside IR35, you can continue paying tax and claiming expenses through your company. Contracts where you are classed as a contractor, not an employee, are exempt from IR35 rules.
This means you can pay yourself a salary, draw income as dividends, and remain responsible for your tax reporting.
Financial impact of being inside IR35
When you work inside IR35, you're considered an employee for tax purposes. This means your client, or the agency that pays you, will deduct Income Tax and National Insurance contributions (NICs) directly from your payment, just like they would for a regular employee.
You may also need to pay the employer's portion of National Insurance contributions, so your take-home pay may be less than if you were working outside IR35. However, this can reduce your admin, as your client handles tax deductions.
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 three IR35 tests:
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 will review the terms of the written contract where available, and evaluate the working practices you have in place, too. Note: if you work for a small business, you'll be responsible for determining IR35 status yourself. A client loses its 'small company' exemption by meeting TWO of the...THREE conditions related to turnover, balance sheet total, and number of employees.
The law is nuanced and cases are reviewed on an individual basis. A recent case against the Professional Game Match Officials Limited (PGMOL) became increasingly complex, as it was debated whether companies are obligated to provide referees with work – making them employees under the mutuality of obligations criteria.
Even if some of the criteria resonate with you, it does not guarantee you are working inside or outside IR35 – though it is a useful indicator.
The difference between inside and outside IR35 is not always easy to spot, so talk to an accounting professional if you are unsure.
What to do if you're inside IR35
If your contract is determined to be inside IR35, your client is responsible for handling your tax. They must provide you with a Status Determination Statement (SDS) that explains their decision, and since April 2021, clients must also have a process that allows contractors to disagree with the decision. From there, they will deduct the necessary Income Tax and National Insurance from your fees before paying you.
Working through an umbrella company
For many contractors, an umbrella company can be a straightforward way to work on inside IR35 contracts. An umbrella company acts as your employer. They receive payments from your client, then pay you a salary after deducting all necessary taxes, such as income tax and National Insurance.
This simplifies your tax affairs, as you become an employee of the umbrella company, ensuring you are compliant with IR35 rules without the need to run your own limited company for that contract.
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
For businesses hiring contractors:
- 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 the advisor directory.
For more help running your own business, see the small business guides.
Managing your finances with the right tools
Whether you're working inside or outside IR35, keeping your finances organised is key to running a successful business. With clear records, you can easily track your income from different contracts, manage your expenses, and get a real-time view of your cash flow.
Accounting software helps you stay on top of your financial obligations and makes it simple to share information with your accountant. This gives you the confidence to make smart business decisions and focus on what you do best. Start a free trial of Xero accounting software to see how easy it can be.
Frequently asked questions about inside IR35
Here are some common questions contractors have about IR35.
How is take-home pay calculated inside IR35?
Your take-home pay is calculated after your client or fee-payer deducts Income Tax and both employee's and employer's National Insurance contributions from your gross invoice amount. This is similar to how an employee's salary is processed through PAYE. The exact amount depends on your total earnings and tax code.
Is it better to be inside or outside IR35?
Neither is inherently 'better' – it depends on your circumstances. Working outside IR35 typically offers greater tax efficiency and control over your business finances. Working inside IR35 provides simplicity, as your taxes are handled for you, but usually results in lower take-home pay for the same day rate.
Who decides if a contract is inside IR35?
For medium and large businesses in the private sector, the client who hires you is responsible for determining your IR35 status, a responsibility that made the switch to the end-user business in April 2021. They must provide you with a Status Determination Statement (SDS). However, if your client is a small business, the responsibility for determining your status falls to you.
Disclaimer
Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.
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