An introduction to IR35

For many years, people leaving jobs to become self-employed were advised to instead set up one-man companies to provide their services.

One reason for this might be the security offered by limited liability, but in many cases the use of a 'personal service company' was to create the opportunity for some quite substantial savings, particularly of national insurance contributions (NICs).

Consider James and Robert, who have for many years worked as managers in a local professional business. They have, until now, each been paid a salary of £75,000 a year. In 2020/21, each would pay income tax of £17,500 and primary class 1 NICs of £5,360.

In addition, their employer would pay secondary class 1 NICs of £9,137.26 x 2 = £18,274.52. So, at a cost to his employer of £84,137.26, James would receive £52,140.00 net. Likewise Robert.

James and Robert decide to become self-employed. James finds office accommodation and begins to build up his own client base.

Robert instead arranges to work for different firms - say mornings for one and afternoons for a second.

In the first case, there is little doubt that James's change to self-employment would be genuine, but in the second there is a strong case for saying that rather than having become self-employed, Robert in reality has two jobs, and PAYE tax and NICs (both primary and secondary) are payable.

The rules for people like James and Robert have existed for many years, and you can read more about them on our guide 'Employed or self employed?' As you will see, the tests for deciding whether someone is accepted as self-employed for tax purposes are a little vague, but if Robert in reality has what amount to two part-time jobs, the mechanics exist for him to be classified as an employee of the two firms he works with, and for PAYE to be operated accordingly. The effect of all this is for extra costs, in the form of primary and secondary class 1 NICs to be payable by Robert and his employers.

A possible solution

To avoid this, Robert could in the past have set up a limited company, and contracted for the company to provide his services to the 2 customers. Robert would then have been both the owner of, and an employee of, his own personal service company.

Robert could then choose to take part of his remuneration in the form of dividends - with scope for a substantial increase in his income.

Assume that Robert's company has profits, before Robert takes any salary or dividends of £75,000 and that he takes £8,788 in salary before employer NICs are potentially payable and the balance of the profits, after tax, in the form of dividends.

First, we need to consider the company's tax position - the company will have to pay Robert his salary but there are no NICs due as Robert is not paid in excess of the threshold.

The remaining profit will be charged to corporation tax - amounting to £12,580. On this basis, Robert can take net dividends of £53,632 - plus, of course, his salary of £8,788.

Robert's tax position for 2020/21 would be:

Salary £8,788 Gross income £62,420
Dividend £53,632  
  Income tax £6,699
Gross income (say) £62,420  
Personal allowance £12,500
Taxable income £49,920  
  Net income £55,721
Dividend allowance @ 0% on £2,000  
Dividend tax @ 7.5% on £35,500  
Dividend tax @ 32.5% on £12,420 Compared with £52,140
Tax due £6,699  
  A saving for Robert of £3,581

The aim of the IR35 legislation is to stop people who, if they were claiming to be self-employed would in fact be re-classified as employees with all the consequences for primary and secondary class 1 NICs, using an intermediary. This intermediary is in the form of a personal service company or a partnership to obtain a tax advantage over other workers.

IR35 achieves this by forcing the company to operate PAYE in respect of an amount of notional remuneration, being basically the difference between the company's profit on work caught by the IR35 rules and the remuneration drawn by the owner-director in respect of that work. For more details, and an example of the calculation of notional remuneration, see our separate guide on personal service companies.

Of course, on the facts, James will not be caught by the IR35 rules, and could set up a limited company through which he can operate his business and even negotiate the employer's NICs savings to be added on top, which we will see in the calculations below. For more details on the pros and cons of running your business through a limited company, see 'Should You Form a Limited Company?'.

Operating his business through a limited company could save James just over £2,000, compared with operating as a self-employed sole practitioner.

Self-employed profit £84,158.78 Gross income £84,158.78
Personal allowance £12,500  
Taxable £71,658.78 Income Tax £21,163.51
    Class 2 NICs £156.00
Tax at 20% on £37,500 £7,500  
Tax at 40% on £34,158.78 £13,663.31 Class 4 NICs £4,406.30
Total tax £21,163.51  
  Net income £58,432.97
Class 2 NICs £156.00  
  Compared with (as above) £60,708.33
Class 4 NICs £4,406.30  
  Costing James £2,275.39