IR35 Inside vs Outside: The Tax Implications for UK Contractors in 2025

Working inside IR35 can cost a UK contractor £15,000 to £25,000 per year in additional tax compared to working outside IR35 on the same day rate. The difference comes from losing access to dividend tax treatment, paying employee National Insurance on deemed employment income, and having income taxed through PAYE rather than the more flexible limited company structure.

This guide explains exactly how the tax works in each scenario, with worked examples at common contractor income levels, so you can understand the financial impact before accepting an inside-IR35 contract. Use our IR35 calculator to model the precise take-home difference for your own day rate and working pattern.

What changes when you move inside IR35

Outside IR35, your limited company invoices the client for your services. The company receives the fee, pays corporation tax on profits, and you extract money through a combination of salary and dividends. Dividends are taxed at lower rates than employment income and do not attract employee or employer National Insurance.

Inside IR35, the fee your company receives is treated as deemed employment income. Your company must operate PAYE on this income, deducting income tax and employee National Insurance before paying you. You cannot treat the bulk of the fee as dividends. The result is that almost all of the contract income is taxed as if you were a permanent employee, but without the employment benefits that come with a staff role.

For a fuller explanation of how IR35 status is determined and who makes the decision, see our IR35 guide for UK contractors.

UK tax rates that apply in 2025/26

The tax implications of IR35 status only make sense in the context of current UK rates. For the 2025/26 tax year, the key figures are as follows.

These rates apply regardless of IR35 status, but which taxes you pay and on what income depends entirely on whether you are inside or outside the rules.

Outside IR35: how the tax works

A contractor outside IR35 running a limited company typically takes a small salary up to the personal allowance or primary NI threshold, then extracts the remaining profit as dividends. This is the structure that makes limited company contracting tax-efficient.

On a £110,000 annual contract fee (£500 per day for 220 days), the company might pay a salary of £12,570, leaving roughly £97,430 in profit before corporation tax. Corporation tax at 19% on profits below £50,000 and 25% above takes approximately £22,000, leaving around £75,400 available for dividends.

Dividends are taxed at 8.75% in the basic rate band and 33.75% in the higher rate band, after a £500 dividend allowance. The contractor pays no employee National Insurance on dividends. Total take-home after all taxes is typically in the range of £72,000 to £78,000 on this level of income.

Allowable expenses outside IR35

Outside IR35, your company can deduct legitimate business expenses before calculating corporation tax. This includes accountancy fees, professional indemnity insurance, equipment, software subscriptions, travel to client sites, and a proportion of home office costs. These deductions reduce the profit subject to corporation tax and increase the amount available for dividends.

Inside IR35, allowable expenses are far more restricted. You cannot deduct most business costs from deemed employment income. The only deductions typically permitted are a 5% expenses allowance (if you meet certain conditions), pension contributions, and certain statutory payments. This restriction alone can add thousands to your tax bill.

Inside IR35: how the tax works

Inside IR35, the entire contract fee (minus a 5% expenses allowance in some cases) is treated as employment income for tax purposes. Your company must run PAYE on this amount, deducting income tax and employee National Insurance at source before paying you.

On the same £110,000 contract fee, the deemed employment income of £110,000 is taxed as follows. Income tax of approximately £33,500 after the personal allowance. Employee National Insurance of approximately £5,200. Employer National Insurance of approximately £13,800 is also due, though this is technically a cost to the company rather than a direct deduction from your pay. In practice, many clients or agencies factor employer NI into the rate they offer for inside-IR35 contracts.

Take-home pay on £110,000 inside IR35 is typically around £54,000 to £58,000 after all deductions, compared to £72,000 to £78,000 outside IR35. The gap of £15,000 to £20,000 is the real cost of an inside-IR35 determination.

Worked comparison at three income levels

The tax gap between inside and outside IR35 is not linear. It widens as income rises because higher-rate tax and NI apply to a larger proportion of the fee when taxed as employment income.

These figures are illustrative and depend on your salary and dividend split, pension contributions, and allowable expenses. Run your own numbers through the IR35 calculator for a precise comparison.

National Insurance: the hidden cost

National Insurance is where much of the IR35 tax penalty sits. Outside IR35, contractors pay employee NI only on their salary, which is typically set at the personal allowance level. Dividends attract no NI at all. Inside IR35, employee NI at 8% applies to all deemed employment income above £12,570, and employer NI at 13.8% is also due on earnings above the secondary threshold.

On £110,000 of deemed employment income, employee NI alone is approximately £5,200. Outside IR35 on the same income, employee NI on a £12,570 salary is just a few hundred pounds. The NI difference between the two structures can exceed £10,000 per year at higher contract values.

Class 2 NI for self-employed individuals was abolished from April 2024, which removed one potential alternative for contractors considering leaving the limited company structure. The comparison for most contractors is now between limited company (outside IR35), limited company (inside IR35 with deemed payment), and umbrella company employment.

Dividend tax: what you lose inside IR35

Dividend tax rates are deliberately lower than income tax rates to reflect that company profits have already been subject to corporation tax. For basic rate taxpayers, dividends are taxed at 8.75% compared to 20% income tax. For higher rate taxpayers, the rate is 33.75% compared to 40% income tax.

Inside IR35, you lose access to this treatment entirely. The contract fee is taxed as employment income at full income tax rates with no corporation tax step in between. Even though the headline income tax rates look similar, the inability to use the salary-plus-dividend structure means you pay significantly more overall.

The £500 dividend allowance provides a small tax-free amount for dividends each year, but this is irrelevant inside IR35 since no dividends are available from the contract income. If you have other investments generating dividends outside your contracting income, the allowance still applies to those.

Pension contributions under each structure

Pension contributions are one area where inside-IR35 contractors retain some tax efficiency. Employer pension contributions made by your limited company on deemed employment income are deductible from the deemed payment before PAYE is calculated. This reduces the income tax and NI due on the contract fee.

Outside IR35, employer pension contributions are also deductible from company profits before corporation tax. The tax relief is similar in effect, though the mechanics differ. Making pension contributions is a legitimate way to reduce the tax impact of an inside-IR35 determination, and many contractors increase their pension contributions significantly when moving inside IR35 to offset part of the take-home reduction.

The annual allowance for pension contributions is £60,000 for most people in 2025/26, though this reduces for very high earners. Unused allowance from the previous three years can be carried forward. For contractors facing an inside-IR35 determination, maximising pension contributions within the allowance is often the most tax-efficient response.

Umbrella company vs inside-IR35 limited company

When working inside IR35, some contractors use an umbrella company rather than their own limited company. The umbrella employs you, receives the contract fee from the agency or client, deducts PAYE and NI, and pays you the remainder. The tax outcome is broadly similar to operating inside IR35 through your own company.

The main differences are administrative. An umbrella handles all payroll obligations, which simplifies compliance. You pay a margin to the umbrella, typically £20 to £30 per week, which is an additional cost on top of the tax difference. Your limited company can remain dormant while you work through an umbrella, ready to use again for outside-IR35 contracts.

For contractors who expect to work mostly inside IR35 for an extended period, the umbrella route is often simpler. For those who anticipate returning to outside-IR35 work, keeping the limited company active and running deemed payments through it may be preferable despite the additional administration.

Should you negotiate a higher rate for inside-IR35 work?

Many contractors negotiate a higher day rate when accepting inside-IR35 contracts to compensate for the additional tax. The increase needed depends on your marginal tax rate and the size of the gap at your income level. As a rough guide, you need an increase of 25% to 35% on your outside-IR35 rate to achieve the same take-home pay inside IR35.

On a £400 per day outside-IR35 rate, you would need approximately £500 to £540 per day inside IR35 to match take-home pay. Not all clients will agree to this increase, particularly in competitive markets. But understanding the number gives you a clear negotiating position and helps you decide whether an inside-IR35 contract is worth accepting at the offered rate.

If you are weighing up whether to operate as a sole trader or through a limited company for non-IR35 work, the sole trader vs limited company calculator compares the tax position across both structures at your income level.

Record keeping and HMRC enquiries

Whether inside or outside IR35, good record keeping protects you if HMRC questions your tax position. Outside IR35, you should document the genuine business nature of your engagements: contracts, evidence of substitution rights exercised, records of working for multiple clients, and invoices showing business-to-business relationships.

Inside IR35, keep copies of Status Determination Statements, records of any challenges you made to determinations, and documentation of pension contributions and allowable deductions. HMRC can investigate IR35 positions for open tax years going back four years, or six years if they believe there has been careless behaviour.

The tax implications of getting IR35 wrong are serious. If HMRC determines you should have been inside IR35 for past years, you can face demands for unpaid income tax, employee NI, employer NI, interest, and penalties. The amounts involved can run to tens of thousands of pounds for a single tax year at mid-range contract rates.