If you are self-employed, you will need to be aware of IR35, what it means for your business and its tax implications. This article will look at how IR35 applies to sole traders specifically, by covering the following areas:

  • What is IR35?
  • How does IR35 work?
  • What is ‘inside’ IR35?
  • What is ‘outside’ IR35?
  • How does IR35 apply to sole traders?

What is IR35?

IR35 refers to the difference between an employee and a contractor. First, an employee is an individual employed by a business, they answer to a manager in the company and are employed for a salary, regardless of how much work there is to do. A contractor, however, is paid a fee for a temporary period of work (though this can be long-term), and will generally be let go by the company when the work is complete or there is not enough work available to support having them employed.

IR35 is a piece of tax-avoidance legislation to prevent both businesses and contractors abusing loopholes. It is more tax efficient for a company to employ a contractor because they do not have to pay National Insurance for the individual, as well as saving money on other benefits that an employee would enjoy. such as:

  • Paid holiday
  • Pension contributions
  • Sick leave

IR35 arose because companies were hiring contractors through limited companies (many contractors are self employed by their own limited company) and the contractor’s duties for the company were more or less the same as an employee’s – and it was saving both the contractor and the business tax. This relationship of a contractor acting as an employee, but not being called one, is called ‘a disguised employee’.

So when IR35 comes into play, the law protects contractors and companies against the other party exploiting the tax system, as well as preventing HMRC from losing tax they are in fact due.

How does IR35 work?

IR35 acts to identify if disguised employees are operating within a business, and ensures they and the business pay the tax they owe. It’s not a perfect system and often there may be contractors who are employed by their own limited company and are in fact paying the correct tax but look more like an ‘employee’. To ensure everyone is compliant, an investigator is appointed by HMRC to look at the relationship between the contractor and the company.

The inspector will determine whether contractors fall ‘inside’ IR35 (employee status) or ‘outside’ (contractor status).

What is ‘inside’ IR35?

If a contractor falls inside IR35 they are treated just as an employee would be, and going forward will be treated as an employee by the business for tax collection, paying National Insurance and Income Tax, which the business will deduct from their pay like a normal employee salary.

What is ‘outside’ IR35?

Contractors that fall outside of IR35 will be paid as a contractor, without the benefits of employment by the company. They will be paid by the company but will take their salary from their limited company (that they operate their freelance work from) or from a recruitment agency/third party that manages contractors. Contractors in this situation will continue to be responsible for managing their own taxes.

How does IR35 apply to sole traders?

Simply put, IR35 does not apply to sole traders. This is because sole traders operate as a self-employed person without using a limited company. Very rarely are contractors operating as sole traders, because the Income Tax (Earnings and Pensions) Act 2003 does not allow self-employment when a recruitment agency is involved in the employment of the contractor to the client business.

Also, recruitment agencies and client businesses are less likely to hire individuals operating as sole traders because if you are subsequently found to be an ’employee’ by an HMRC IR35 investigator, then you could claim employment benefits from the recruiter or company itself.  They would also become responsible for tax and National Insurance contributions for you.

It is also in the individual’s interest to operate as a limited company, instead of as a self-employed sole trader:

  • The limited company status gives off a more professional image.
  • Your liability is limited, as there are shareholders involved.
  • There are some tax benefits for trading via a limited company.

IR35 will likely only affect you if you are a contractor that works for a limited company. If you are self-employed but work through a limited company that employs contractors (such as a recruitment agency) and you deal with the client business through this agency, then your tax contributions should be handled by the agency through the regular PAYE process.

If you are a contractor, then it’s important to understand this legislation and stay on the right side of HMRC, as you don’t want to be mistaken for manipulating the tax system. If your contractor status is in question there are ways you can prove that your relationship with the employing business is different from their own employees:

  • Highlight that you don’t have minimum hours or other requirements that an employee would have.
  • Don’t name your limited company after yourself.
  • Prove you have your own business insurance.
  • Show you have multiple clients at once by showing your invoices.
  • Keep a record of any investment in your own professional development (as usually businesses will pay for their own employees to remain certified).

Make tax and accounting simple

Now that you know more about IR35 and if it applies to your business, let Countingup help your business by making the rest of your tax worries simple.

You can download the Countingup app and make your bookkeeping easy by trying the business current account with built-in accounting software today.  

It could save you hours of accounting admin, by automating invoicing and receipt taking. Countingup keeps your books reliable and organised for you or your accountant to manage easily. Find out more here and try it today.