Inside vs Outside IR35: What UK Contractors Need to Know

What is IR35?

IR35 — also known as the off-payroll working rules — is a set of UK tax rules introduced by HMRC to tackle disguised employment. It targets contractors who work through their own limited company (a personal service company, or PSC) but, in reality, operate just like an employee of the end client.

The aim is simple: if your day-to-day working relationship looks like employment, you should pay broadly the same tax and National Insurance as an employee — regardless of how you're paid.

Why IR35 exists

Limited company contractors can legitimately pay themselves through a small salary and dividends, which historically attracted significantly less tax and National Insurance than a full PAYE salary. HMRC saw thousands of workers using PSCs to do the same job as employees while paying much less tax.

• Contractors working alongside employees on identical terms
• Tax differences between salary and dividends
• HMRC enforcement and the shift in liability to end clients

What inside IR35 means

If a contract is judged inside IR35, HMRC treats the engagement as employment for tax purposes. The fee-payer (usually the agency or end client) must run PAYE on the contractor's income before paying it across.

• Income is taxed via PAYE — Income Tax and employee NI
• Most contractors use an umbrella company for simplicity
• Employer NI and the Apprenticeship Levy come out of the assignment rate
• Tax efficiency from a limited company effectively disappears

What outside IR35 means

A contract that's outside IR35 is a genuine business-to-business arrangement. The contractor runs their own limited company, invoices the client, and decides how to pay themselves — typically a small director's salary plus dividends.

• Genuine business-to-business engagement
• Limited company (PSC) used for invoicing and payments
• Salary plus dividends structure for tax efficiency
• Higher take-home potential than inside IR35 or PAYE

Tax differences explained

Inside and outside IR35 income passes through completely different tax machinery. The table below summarises the main differences.

Umbrella companies and IR35

Umbrella companies are the default solution for inside IR35 contracts. The umbrella employs the contractor, runs PAYE payroll, handles holiday pay and pension auto-enrolment, and pays the contractor a net salary each week or month.

• Required for most inside IR35 assignments
• Simple — no accountant, no company admin
• Compliant by design (PAYE handled at source)
• Employer costs and umbrella margin reduce take-home pay

For a full breakdown, see our umbrella take-home pay guide or run the numbers in the Umbrella Company Calculator.

Limited companies and IR35

A limited company (PSC) is the most tax-efficient structure when a contract is genuinely outside IR35. You become a director, pay yourself a small salary, and take the rest as dividends after corporation tax.

• Best suited to outside IR35 contracts
• Bookkeeping, VAT and payroll responsibilities
• Specialist contractor accountant typically £80–£150/month
• Tax planning across salary, dividends and pension
• Profits can be retained in the company for future years

Try our Contractor Calculator to model a typical outside IR35 take-home calculation.

Who determines IR35 status?

Since the 2021 reforms, the responsibility for deciding IR35 status depends on the size of the end client.

• Medium and large private-sector clients: the client decides and issues a Status Determination Statement (SDS).
• Public-sector clients: always responsible for determining status.
• Small private-sector clients: the contractor's own company makes the determination — the small company exemption.

How IR35 affects take-home pay

The same headline day rate produces very different net income depending on IR35 status. Here are two simplified examples at £500/day over 220 billable days (£110,000/year).

£500/day inside IR35 (umbrella)

• Employer NI, Apprenticeship Levy and umbrella margin deducted first
• Remaining gross taxed via full PAYE
• Typical take-home: roughly £62k–£66k per year

£500/day outside IR35 (limited company)

• Small director salary plus dividends after corporation tax
• No employer NI on dividends
• Typical take-home: roughly £78k–£84k per year

Common IR35 tests

HMRC and tribunals look at the working relationship as a whole, but these factors carry the most weight.

• Control: who decides what, how, when and where the work is done?
• Substitution: can you genuinely send a substitute to do the work?
• Mutuality of obligation: is the client obliged to offer work and you obliged to accept it?
• Financial risk: do you risk your own money, equipment, or fixing defects at your own cost?
• Business independence: do you operate like a genuine business — multiple clients, marketing, insurance?

HMRC risks and penalties

IR35 enquiries can be expensive. If HMRC successfully challenges a status determination, the fee-payer (or the contractor's company in small-client situations) can face significant liabilities.

• Back taxes and employee/employer National Insurance
• Interest on unpaid amounts
• Penalties of up to 100% for careless or deliberate errors
• Multi-year reviews going back several tax years

Common contractor mistakes

• Assuming every limited company contract is automatically outside IR35
• Using a PSC for an inside IR35 contract with no tax benefit
• Ignoring or not challenging an SDS issued by the client
• Forgetting employer NI is deducted from the assignment rate inside IR35
• Comparing gross day rates rather than net take-home pay