Inside vs outside IR35 in the UK: How do they differ?

Off-payroll working rules, or IR35, is a tax legislation that determines whether an independent contractor is considered “on-payroll” or “off-payroll”. On-payroll workers are considered inside IR35, while off-payroll workers are classified as outside IR35.

Your IR35 status affects how much income tax you pay and your National Insurance contributions (NIC), so it’s vital that your classification is determined correctly the first time. If HMRC determines after an audit that you have the wrong IR35 status, you or your client would be subject to a large tax bill and penalties.

In this article, we’ll discuss the key differences between inside and outside IR35 so you can better understand how each classification affects you. We’ll also go through the details on how to determine your IR35 status properly, what happens if it’s wrong, and what you can do to change your status.

Key differences between inside and outside IR35

Here’s a quick glance at the differences between inside and outside IR35:

It’s important to remember that IR35 classifications are determined on a case-by-case basis. 

Even if your client is responsible for declaring your IR35 status, it’s still beneficial to have a third-party IR35 compliance assessor double-check your contract specifics so you can avoid any issues later.

In the following sections, we’ll look at inside and outside IR35 in detail.

What is inside IR35?

When you’re inside IR35 rules, you pay income tax and NIC the same way as your client’s employees. These are deducted automatically through PAYE, so your take-home pay would be lower than if you were outside IR35 (more on this later).

Your work is also slightly more exclusive to your client when you’re inside IR35. That means some or all of the following may apply, depending on the contract:

• You’re the only one who can perform the job and can’t send another contractor to do it on your behalf.
• You must do the work at a time and place specified by your client, such as at their office during operating hours.
• You work for your client/employer continuously.
• Your employer covers the cost of any equipment and materials you need to perform your task. They also assume any financial risk that could result from your work.
• You appear in your client’s staff directory and may even have a business card with your name. In other words, you’re part of your client’s organisation.
• Your client provides a period of notice for termination before ending your contract.
• You hold a management role within your client’s organisation.
• You signed a “contract of service” with your client. You were hired for your service: a continuous role within the company, performing various tasks as required.

However, just because you work and get taxed the same way as your client’s employees doesn’t mean you receive the same rights and benefits. That means you don’t get any sick pay, paid holidays, employer pension contributions, and other worker rights that full-fledged employees enjoy. You’re only considered an employee for tax purposes.

What is outside IR35?

Being outside IR35 rules means you’re responsible for paying yourself your salary, income tax, and NIC after your client pays your invoice. Unlike inside IR35, where income tax and NIC are deducted automatically, you calculate how much tax and NIC you pay based on your Self Assessment results.

We mentioned earlier that being outside IR35 means a higher take-home pay than inside IR35. That’s because employees pay a slightly higher NIC rate and have other deductions (such as workplace pension) taken out of their salary. 

On the other hand, a self-employed contractor pays income tax and NIC based on their Self Assessment results. And if the contractor has a limited company, they can withdraw dividends as part of their income and deduct business expenses from their taxable profits.

Working outside IR35 rules also gives you more flexibility on how you work. Here’s how:

• You can do the work yourself or have someone else complete it for you.
• Depending on the job, you can do it at a time and place that works for you.
• Your work ends (and the contract is fulfilled) once the project is finished. 
• Your contract is only for the specific services you agree to provide for your client.

However, this flexibility also means you need to remember a few things that employees don’t have to worry about:

• You bear all the financial risk and responsibilities for your business.
• You’re responsible for any materials and equipment you need for your work.
• You handle all aspects of your business, such as advertising, taking appointments, issuing invoices, and VAT registration.

Who decides if a contract is inside or outside IR35?

Who declares your IR35 status to HMRC depends on who your client is:

Whoever declares your IR35 status must submit a Status Determination Statement, or SDS for short. This can be submitted as a document or an email, and it explains the reasoning for your IR35 status.

Is my contract inside or outside IR35?

Whether you’re inside or outside IR35 depends on your contract terms. There are several ways for you to determine your IR35 status, even if you’re not the one responsible for declaring it:

• Hire an accountant or third-party IR35 compliance assessor: Accountants and IR35 compliance assessors know tax laws inside and out, so it’s beneficial to get their advice. Compliance assessors can be particularly helpful if you want to double-check your status (to avoid an HMRC audit) or if you have to submit the SDS yourself.

• Use the HMRC’s Check Employment Status for Tax (CEST) tool: CEST is helpful when you’re responsible for declaring your own IR35 status. You can also use the tool to see how your client made their decision or how the changes in your contract affect your current IR35 status.

• Do the IR35 status test: These questions are designed to help you figure out whether you’re inside or outside IR35. The questions are:

• • Right of substitution: Can someone else (i.e. another contractor of your choosing) complete the work on your behalf?

• • Control: Who decides when, where, and how you do the work?

• • Mutuality of Obligation (MoO): Is your contract fulfilled after the project is finished, with no expectation of further work?

• • Financial Risk: Who’s responsible for business expenses?

• • Organisation: Do you enjoy the same perks as your client’s employees, or are you simply there to provide your services?

• • Right of dismissal: Does your contract specify a notice period before it can be terminated?

• • Exclusivity: Do you work for one client exclusively?

• • Role: Will you be given a management role in your client’s business?

• • Intention: Is the contract for your services (a specified range of functions you provide) or for your service (a continuous role within your client’s business)

Keep in mind that the HMRC can audit your status anytime, so keep detailed records of your business activities, tax documents, copies of your contract(s), and any relevant communications to support your case.

What if my IR35 classification is wrong?

If HMRC determines after an audit that you have the wrong IR35 status, you can appeal their decision. You’ll need to prove that your current IR35 status is correct and provide evidence supporting your claims. If the first appeal is unsuccessful, you can take it up to a Tax Tribunal, then to the Higher Courts. Appeals are time-consuming and expensive, so consider this when challenging the audit results.

However, if you agree that you had the wrong IR35 status, what happens next depends on what your previous status was and who originally submitted the SDS:

• If you were incorrectly classified as Inside IR35: You can request an IR35 tax refund with the help of an accountant. HMRC will not inform you if you’re due a refund, so you must submit this request yourself. Public sector contractors can claim for contracts all the way back from 2017, while private sector contractors can claim from 2021 onwards.

• If you were incorrectly classified as Outside IR35: Whoever submitted the SDS (also referred to as the end-hirer) is liable for paying any unpaid taxes and NIC due. 

There’s also a penalty, which is based on what the HMRC thinks the reason is for the incorrect declaration:

• An extra 30% on top of the unpaid tax if the end-hirer was careless about the classification, but was genuinely unaware of the mistake.
• An extra 70% on top of the unpaid tax if the end-hirer knew about the incorrect classification and chose to ignore it.
• An extra 100% on top of the unpaid tax if the end-hirer actively tried to hide the incorrect classification and tax underpayment.

Can I change my IR35 status?

You can change your IR35 status depending on your situation.

If you think your client has declared you outside IR35 by mistake, you can challenge their decision using the IR35 disagreement process. The end-hirer has 45 days to decide whether to change your status. If they agree, they must submit a new Status Determination Statement (SDS) with an updated reasoning for the IR35 status change.

You can also change your contract terms in a way that allows you to change your IR35 classification. The end-hirer must submit a new SDS with an explanation of the change.

Is it better to work inside or outside IR35?

We cannot advise whether being inside or outside IR35 is better or worse, as everyone’s circumstances are different. Your classification depends on your contract details, and setting your IR35 status correctly is always important. Otherwise, you or your client will have to pay back any unpaid tax, plus a penalty. 

Quickfire summary: What does inside and outside IR35 mean?

IR35 is legislation aimed at closing tax loopholes for self-employed workers, ensuring they pay the right amount of tax depending on their contract terms. You can either be inside or outside IR35 rules.

When you’re inside IR35 rules, you’re an on-payroll worker. You pay income tax and National Insurance contributions (NIC) the same way as your client’s employees. In other words, your taxes are deducted from your salary automatically based on PAYE.

On the other hand, being outside IR35 means you’re off-payroll, so taxes aren’t automatically deducted from your pay. Instead, your client pays your invoice as agreed, and you handle tax and NIC payments yourself based on your Self-Assessment results.

The main criteria used to determine your IR35 status are:

• Right of substitution: Do you have to complete the work yourself?
• Control: Do you have control over how you work?
• Mutuality of Obligation: Do you keep working for your client after the project is finished?

Your contract details determine whether you’re inside or outside IR35, and it’s usually your client’s responsibility to submit a Status Determination Statement. You may have to submit the SDS yourself if your client is considered a small private-sector business.

The wrong IR35 classification can result in a large tax bill and penalties from the HMRC. However, you can challenge your client’s decision if you disagree with your classification and want it changed.