IR35 and Off-Payroll Working: A Plain-English Guide for UK Small Businesses
IR35 is widely misunderstood — by contractors and the businesses that engage them. The April 2026 threshold changes have shifted the rules for around 14,000 companies that have been engaging contractors for the first time in years. Here’s how IR35 works, who it affects, and what the changes mean for your business.
What is IR35?
IR35 is the shorthand name for the off-payroll working rules — tax legislation designed to prevent “disguised employment.” The rules target a specific situation: an individual who works through a limited company (a Personal Service Company, or PSC) but who effectively works like an employee — taking direction from one client, working set hours, unable to genuinely send a substitute.
If a contractor is “inside IR35” — working like an employee regardless of their company structure — HMRC expects them to pay the same income tax and National Insurance as an employee. The limited company wrapper is ignored for tax purposes.
Inside vs outside IR35: the key tests
IR35 status depends on the reality of the working relationship. Three tests dominate most determinations:
| Test | Points towards outside IR35 | Points towards inside IR35 |
|---|---|---|
| Substitution | Contractor has a genuine, exercisable right to send a substitute — and the client would accept one | Substitution clause exists on paper but would never be exercised in practice; client expects personal service |
| Control | Contractor decides how and when to do the work; client controls only the outcome | Client controls working methods, hours, and location; contractor attends internal meetings as a staff member |
| Mutuality of obligation | Work is project-based with a defined end; no expectation of ongoing engagement | Both parties implicitly expect continued work to be offered and accepted indefinitely |
| Financial risk | Contractor bears genuine financial risk — must redo substandard work at own cost, or has invested in equipment | No meaningful financial risk; contractor is paid regardless of quality |
| Integration | Contractor operates independently, uses own equipment, works for other clients | Contractor has company email, attends company events, is managed through the same processes as employees |
Who decides IR35 status?
| Type of client | Who determines IR35 status? | Obligation |
|---|---|---|
| Small private sector businesses | The contractor’s own PSC | Exempt from the off-payroll working rules — contractor self-assesses |
| Medium and large private sector businesses | The client (end user) | Must issue a Status Determination Statement (SDS) to the contractor and fee payer; must operate a formal disagreement process; respond to contractor challenges within 45 days |
| Public sector bodies | The client (public body) | Same obligations as medium/large private sector — in place since April 2017 |
The April 2026 threshold changes: what small businesses need to know
From 6 April 2026, the financial thresholds for “small company” status under IR35 increased significantly:
| Threshold | Before April 2026 | From April 2026 |
|---|---|---|
| Annual turnover | Up to £10.2 million | Up to £15 million |
| Balance sheet total | Up to £5.1 million | Up to £7.5 million |
| Employees | Up to 50 | Up to 50 (unchanged) |
A business is classified as small if it meets at least two of the three criteria. Around 14,000 companies moved from medium to small as a result — shifting IR35 responsibility back to the contractor’s PSC.
What “inside IR35” means in practice
The fee payer (usually the agency, or the client if there’s no agency) operates PAYE — deducting income tax and National Insurance before paying the contractor’s PSC. The PSC receives the net amount. There is a 5% allowance for limited company running costs but this offers limited relief. The financial impact on the contractor is material.
The contractor’s PSC calculates and pays the deemed employment payment through its own payroll, accounting for the tax and NIC that would have been due if the income were employment income. The contractor does this themselves rather than it being deducted by the client or agency.
In both cases, a contractor moving from outside to inside IR35 loses a significant portion of their effective income. The difference between employment tax rates and the salary/dividend structure is precisely the financial reason contractors operate through PSCs.
Joint and several liability — new from April 2026
From April 2026, joint and several liability rules apply to umbrella company arrangements. Where PAYE is not correctly operated within the labour supply chain, HMRC can recover unpaid tax from multiple parties — including agencies and, in some cases, end client businesses — not just the umbrella company itself.
CEST: HMRC’s status checking tool
HMRC’s free online tool — Check Employment Status for Tax (CEST) — asks questions about the working arrangement and provides a status determination. Available at gov.uk/guidance/check-employment-status-for-tax.
CEST is not definitive, and it’s been criticised for not handling every scenario well. HMRC has committed to standing behind CEST results where the tool has been used in good faith, and the information provided is accurate — but tax professionals sometimes reach different conclusions from the same facts. For complex or high-value engagements, a specialist IR35 review from a tax adviser is money well spent. For smaller, shorter contracts, CEST is a reasonable starting point.
What small businesses engaging contractors should do
If you’re a small business (exempt from off-payroll rules)
- Contractors are responsible for self-assessing their IR35 status — not you. But poorly structured engagements increase the risk of incorrect determinations that could be investigated later.
- If your contractors determine they’re outside IR35, ensure the working practices match that determination. If you manage them as an employee in practice, there’s a greater risk of HMRC reclassification.
- Using CEST to document your assessment of the engagement demonstrates good faith if questions arise later.
If you’ve recently grown into the medium/large category
- Issue Status Determination Statements (SDS) for each contractor engagement — stating whether the contract is inside or outside IR35 and giving reasons.
- Establish a formal disagreement process — contractors can challenge your determination and you must respond within 45 days.
- Ensure the fee payer operates PAYE for any inside-IR35 engagements — this is usually the agency if one is involved.
- Keep records of all status determinations, the reasoning behind them, and the working practices at the time. HMRC can investigate retrospectively.
Common mistakes
IR35 is about working practices, not contract wording. A contract that says “right of substitution” means nothing if it would never be exercised in reality. HMRC looks at what actually happens, not what the paperwork says.
Making a single determination that all contractors are outside IR35 without individual assessment is actively discouraged by HMRC and has been the basis for several high-profile investigations and significant tax bills.
A contractor can be inside IR35 for one engagement and outside for another. Status is assessed contract by contract and role by role — not once per contractor.
HMRC can investigate retrospectively, sometimes going back several years. Records of status determinations, the reasoning behind them, and the actual working practices at the time are essential if you’re ever challenged.
Useful resources
- HMRC CEST tool — check employment status at gov.uk/guidance/check-employment-status-for-tax
- HMRC off-payroll working guidance — gov.uk/guidance/understanding-off-payroll-working-ir35
- HMRC IR35 guidance for contractors — gov.uk/guidance/ir35-find-out-if-it-applies
- Your accountant or tax adviser — essential for any business with regular contractor engagements, or any contractor uncertain about their status
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