IR35 Guide for UK Contractors 2025: Inside vs Outside Explained

IR35 affects every UK contractor working through a limited company. Get it right and you keep significantly more of what you earn. Get it wrong and HMRC can pursue you for years of unpaid tax and National Insurance. Given those stakes, it is worth understanding properly.

This guide explains what IR35 actually means in practice, how the status tests work, who decides your status depending on which sector you work in, and what the real difference in take-home pay looks like.

What IR35 is and why it exists

IR35 is named after a 1999 Inland Revenue press release, which is an unusually obscure origin for something that affects hundreds of thousands of people. The legislation was introduced because the government noticed that a large number of workers were effectively operating as permanent employees but working through personal service companies to pay less tax. Instead of being employees paying income tax and National Insurance through PAYE, they were paying themselves a small salary and taking the rest as dividends, which have always been taxed more favourably.

HMRC's view is that if the arrangement looks like employment in substance, it should be taxed like employment. The legislation targets what it calls disguised employment. A contractor who works exclusively for one client, follows their instructions, works set hours, and has been doing so for years is, in HMRC's eyes, functionally an employee regardless of what the contract says.

Inside versus outside IR35: what it means in practice

If you are working outside IR35, your engagement is treated as a genuine business-to-business relationship. You can pay yourself through your limited company in the most tax-efficient way, taking a low salary and drawing the rest as dividends. This significantly reduces your National Insurance and income tax burden compared to being taxed as an employee.

If you are inside IR35, the fee your client pays your company is treated as deemed employment income. Your company must account for income tax and employee National Insurance on this income under PAYE before paying you. You also lose access to the dividend treatment that makes limited company contracting attractive in the first place. The result is that you pay broadly the same tax as an employee but without employment benefits like sick pay, holiday pay, or pension contributions from your employer.

The gap is typically £15,000 to £20,000 per year at mid-range day rates. This is why IR35 status matters so much and why contractors are rightly cautious about accepting an inside-IR35 determination without scrutiny.

The three tests HMRC uses to assess IR35 status

IR35 status is determined by the nature of the working relationship, not what the contract says. HMRC and the courts use common law employment tests developed over decades of case law. Three factors carry the most weight.

Substitution

A genuine contractor should be able to send a substitute to do the work in their place. If the client specifically hired you as an individual and would not accept a substitute with the same skills, that is a strong indicator of employment. The right to substitute needs to be genuine and exercised at some point to carry much weight, not just a clause added to the contract for IR35 purposes.

Control

Employees work under the direction and control of their employer. They are told what to do, when to do it, how to do it, and where to do it. A genuine contractor has more autonomy. They are engaged to deliver an outcome and have discretion over how they achieve it. If your client dictates your hours, requires you to follow internal processes, manages your day-to-day work, and treats you like a member of staff in all but name, that points toward employment.

Mutuality of obligation

In employment, there is an ongoing obligation on both sides. The employer must provide work and the employee must accept it. A genuine contractor relationship has no such obligation. When a project ends, it ends. There is no expectation of further work and no obligation to make yourself available. If you have been working for the same client for three years on a rolling basis and both sides expect this to continue indefinitely, the mutuality of obligation test starts to look problematic.

Who decides your IR35 status

This changed significantly in 2017 and again in 2021. Before 2017, contractors determined their own IR35 status. In 2017 the off-payroll working rules shifted responsibility to the client in the public sector. In April 2021 the same shift happened in the private sector for medium and large companies.

If your client is a small private sector company, defined as meeting two of the following: annual turnover below £10.2 million, balance sheet below £5.1 million, or fewer than 50 employees, you still determine your own IR35 status. For all other private sector clients and all public sector bodies, the end-client is responsible for assessing and communicating your status through a Status Determination Statement.

Status Determination Statements and how to challenge them

When a medium or large client assesses your role as inside IR35, they must give you a Status Determination Statement explaining their reasoning. You have the right to challenge this through the client's status disagreement process.

The client must respond to your disagreement within 45 days and either maintain their determination with further justification or change it. If you still disagree after this process, your options become more limited. You can challenge it through the courts, but this is expensive and slow. Practically speaking, many contractors in this position either accept the determination, negotiate a higher rate to compensate for the tax difference, or walk away from the contract.

CEST: HMRC's online status tool

HMRC provides a free online tool called Check Employment Status for Tax, or CEST. You answer a series of questions about your working arrangement and it returns an inside, outside, or unable to determine result. HMRC has committed to stand by CEST results provided the information entered is accurate and complete.

The tool has been criticised for not including questions on mutuality of obligation, which is one of the three key tests. It also tends to treat every question as binary when many working arrangements are more nuanced. Several high-profile employment tribunal cases have found status determinations that conflicted with what CEST would have returned. The tool is useful but not definitive, and anyone relying on it for a significant contract should also take advice from an IR35 specialist.

What you can do if your contract moves inside IR35

If a client determines you are inside IR35 for a contract you have been doing, you have several options. You can accept it, in which case you should immediately assess whether the day rate still makes financial sense given the higher tax deductions. You can negotiate a higher day rate to compensate for the additional tax. You can challenge the determination through the formal process. Or you can end the engagement and find an outside-IR35 contract elsewhere.

Some contractors move to umbrella companies when working inside IR35. An umbrella company employs you as an employee, handles all PAYE obligations, and charges a margin for doing so. You lose some flexibility but gain simplicity. Whether it is right for you depends on how many inside-IR35 contracts you are likely to do and for how long.

IR35 investigations and what HMRC looks at

HMRC can investigate IR35 status for open tax years going back several years. They look at the actual working practices, not just the written contract. If your contract says you can send a substitute but you never have and your client has indicated they would not accept one, the contract wording carries less weight than the reality.

Good record keeping is important. If you ever face an inquiry, being able to demonstrate that you genuinely worked as an independent contractor, that you controlled your work, that you worked for multiple clients, and that your relationship had the hallmarks of a genuine business-to-business arrangement makes a significant difference to the outcome.