Inside vs outside IR35:
what's the tax difference?

What is IR35 and how does HMRC determine your status?

IR35, officially known as the Off-Payroll Working Rules, is HMRC legislation designed to identify contractors who work through a personal service company (PSC) but who would otherwise be treated as employees of their client. If HMRC deems you “inside IR35”, your income from that contract is taxed as employment income, removing the tax advantages of operating through a limited company, particularly the ability to extract profits as dividends at lower tax rates.

HMRC applies three key tests to determine employment status. First, substitution: can someone else do the work in your place? If you must perform the work personally with no right to send a substitute, this points towards employment. Second, control: does the client dictate how, when, and where you work? If the client sets your hours, location, and methods, it suggests employment. Third, mutuality of obligation: is the client obliged to offer work and are you obliged to accept it? A genuine business relationship has no such obligation between engagements.

Since April 2021, medium and large private sector organisations that engage contractors must determine IR35 status and issue a Status Determination Statement (SDS) before the first payment. Before this change, contractors determined their own status. Public sector rules have applied since April 2017. Small private sector clients (meeting specific size criteria) still leave the determination with the contractor's PSC.

Inside vs outside IR35: the take-home difference

The financial impact of IR35 status is substantial. When a contractor is deemed inside IR35, the fee-payer (usually an agency or the end client) must deduct Income Tax and employee National Insurance from the contractor's fee before payment, and pay employer National Insurance (15% on earnings above £9,100) on top. This means the contractor's limited company receives significantly less, and the contractor loses the ability to extract profits tax-efficiently through dividends.

For a contractor earning £100,000 gross annual revenue, the difference is typically £10,000 to £15,000 per year. Outside IR35, the contractor pays themselves a small salary (£12,570) and takes the rest as dividends at 8.75% (basic rate). Inside IR35, the full fee is treated as employment income, taxed at 20–40% plus 8–2% employee NI, with an additional 15% employer NI reducing the amount available. The higher the day rate, the wider the gap.

Many contractors compensate by negotiating a higher day rate when working inside IR35. As a rule of thumb, an inside IR35 rate should be approximately 15–20% higher than the outside IR35 equivalent to achieve the same net take-home. This is why the calculator above models both scenarios side by side, so you can set your rate with full visibility of the tax consequences.

How to protect and evidence outside IR35 status

Operating genuinely outside IR35 requires both contractual terms and day-to-day working practices that demonstrate a business-to-business relationship. The contract should include a right of substitution (and you should have exercised or offered it), control clauses that confirm you decide how the work is delivered, and no mutuality of obligation beyond the current project scope.

Beyond the contract, maintain evidence of genuine business operation: use your own equipment, carry professional indemnity insurance, maintain your own company website, have multiple clients (or actively market for new ones), set your own working hours and location where possible, and invoice the client rather than receiving a payslip. Each piece of evidence strengthens your position if HMRC opens an enquiry.

Common IR35 mistakes contractors make

IR35 compliance failures are among the most costly tax mistakes for contractors. The following errors are the ones HMRC targets most frequently in status enquiries and tribunal cases.

Relying on the contract alone. HMRC looks at actual working practices, not just what the contract says. If you work like an employee day-to-day but your contract says otherwise, HMRC will focus on reality.

Never exercising the right of substitution. If substitution is in the contract but has never been used or tested, HMRC may treat it as a paper right only. Document every instance where substitution was offered or used.

Working for a single client for years. Long-term, single-client relationships are a strong indicator of employment. If possible, maintain multiple contracts or take on project-based work to demonstrate genuine business operation.

Missing the SDS challenge window. You have a 45-day window to challenge a client's SDS. Letting this pass without a response limits your options: gather your evidence early and respond within the deadline.

Assuming CEST tool results are definitive. HMRC's CEST tool provides guidance but is not binding. Courts have ruled against CEST findings in tribunal cases. Always seek specialist IR35 advice for high-value or borderline engagements.

HMRC deadlines and the SDS process

Medium and large private sector organisations must issue a Status Determination Statement (SDS) to the contractor before the first payment under the engagement. The SDS must state whether the engagement is inside or outside IR35 and give reasons for the determination. If you disagree with the SDS, you have 45 days from receipt to challenge it in writing. The client must then respond within 45 days of receiving your challenge.

If the engagement is determined as inside IR35, the fee-payer must operate PAYE on payments and report them through Real Time Information (RTI) submissions to HMRC. The contractor's limited company can still claim a 5% allowance on gross income to cover the costs of operating through a PSC. This small concession partially offsets the administrative burden of maintaining the company structure.

Contractors working outside IR35 file a Corporation Tax return (CT600) for their limited company and a personal Self Assessment return to declare salary and dividend income. The Self Assessment deadline is 31 January following the end of the tax year. Keeping contemporaneous records of your working practices, not just your contract, is essential evidence if HMRC opens a status enquiry at any point.