As of April 2021, many businesses have been hit with new payroll legislation that might be causing them to overpay on tax or worse, face an investigation and hefty fine from the HMRC.
Both small businesses, freelancers and contractors alike have been feeling the pinch from IR35, which aims to cut down on tax avoidance by disguising employees as freelancers for tax purposes.
In this guide, you’ll discover exactly what IR35 is, who it affects, and how to avoid IR35 so you don’t overpay on your tax.
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What is IR35?
So before digging in on how to avoid IR35, what is IR35 UK, anyway?
IR35 is not a brand new star wars character, but a piece of legislation that’s designed to prevent tax avoidance through employees pretending to be contractors, while reaping the benefits of an employee.
Also known as the ‘off-payroll working rules’, IR35 has been in force in the public sector for a while but has recently introduced new rules for the private sector that might catch businesses off-guard.
The biggest change is that private businesses, whether you’re a sole trader or limited company, take on the sole responsibility of determining if IR35 applies to any employees or contractors that they hire. This might sound simple – but if the HMRC disagrees, they’ll be facing a hefty fine and investigation for tax avoidance.
What’s more, the IR35 might mean a loss of contractors and a more difficult hiring process for these companies.
Who is affected by IR35?
IR35 affects any business that has employees or hires contractors or freelancers. It’s an extra-legal obligation that sole traders and limited companies alike will need to abide by.
Basically, IR35 affects any business that has someone working for them in whatever capacity. It’s all about making sure that anyone that is paid for work by your company is classified and taxed in the correct way.
IR35 won’t just have an impact on employers as it will also affect contractors, especially if they are misclassed. If a contractor is classed as an employee, they’ll be suddenly subject to increased tax or potentially lose their contracts if a company wants to avoid the IR35 costs.
Why is the employee/contractor classification so important?
Employees and contractors have different rights, rules, and taxes.
As an employee, you’ll have benefits such as:
- Holiday and sick pay, including notice periods and statutory leave;
- A long-term and permanent commitment to the company;
- An obligation to receive and complete work on an ongoing basis;
- Pension schemes and redundancy pay.
On the downside to that, employees will be paid through a PAYE system, which automatically deducts tax and national insurance payments from their wages.
On the flip side, contractors or freelancers don’t get the above security and benefits. Instead, contractors and freelancers:
- Set their own hours, schedule and work;
- Can accept or refuse work as they please;
- Are not under obligation to produce ongoing work or long-term commitment to the company;
- Set their own salary, which can vary depending on the project or work they’re completing.
Contractors are not paid through a PAYE system, meaning they self-declare and manage their own taxes. The company does not pay any National Insurance or pension contributions.
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What is a disguised employee?
A disguised employee is when someone is classed and paid as a contractor, but also claims the benefits of an employee, such as holiday pay and sick leave.
Essentially, the worker is an employee in all but name, meaning that both they and the company are claiming reduced tax rates that they aren’t entitled to.
What happens if an employee is classified wrong?
If you’re caught with a disguised employee, you’ll be subject to an IR35 investigation. This could mean:
- Fines and penalties for wrongly classifying your employees and avoiding tax;
- An extra 25% tax on top of your final bill;
- A very long and stressful HMCR investigation.
If you are facing an HMCR investigation, we’ve put together a guide on what happens in HMRC investigations and how you can prepare for one.
But as always, the best preparation is to get your tax right the first time, which we’ll give you more advice on with our tips on how to avoid IR35 below.
Top tips on how to avoid IR35
Want to make sure you’re not hit with hefty fines or overcharged with your tax from IR35? Follow these tips to make sure that you learn how to avoid IR35 and your business stays compliant.
1. Check your contracts
First up, one of the best ways how to avoid IR35 is to check the contracts that you currently have and make sure that they are correctly outlining the work and how it differs from an employee contract.
The key things that you should highlight here are:
The hours and set working conditions
Employees have set hours and timeframes that they work, while contractors set their own conditions and schedules.
Holiday and sick pay
Employees are entitled to leave and will still receive pay. Contractors do not get this benefit and won’t be paid for days they did not work.
Employees are committed to the company for long periods, whereas contractors are not tied into contracts. They can leave at any time, where employees will be required to serve a notice period.
Contracts with other companies
Employees usually work for one company and often have clauses in their contract that prevent them from taking on work outside of this arrangement or working with direct competitors. Contractors are not under these obligations and are free to take on projects from other companies.
If you have any contracts that are unclear, you may want to take legal advice from a solicitor.
2. Keep your correspondence
It’s worth keeping a record and a backup of all emails or correspondence with your worker, in case that you do come under IR35 investigation. These emails can provide further evidence of your working relationship with the worker and the details of the work that is carried out.
For example, if a contractor has emailed you with advance warning that they will be unavailable as they’re taking a holiday, that’s proof that you don’t determine their holidays and that you don’t control their working hours or conditions.
3. Don’t give them branded materials
Freelancers and contractors work for themselves, which means that they have separate branding and materials for their work that are separate from your company.
That divide will act as supporting evidence for your classification, so it’s important that you don’t muddy the waters by supplying contractors with branded material such as business cards.
In addition, it might be a good idea to avoid creating a dedicated office space for contractors. If they work from home, on their own equipment, you help maintain the divide.
4. Request a personal business insurance
When working as a contractor or freelancer, some companies require that they take out certain types of business insurance, like professional indemnity insurance.
If your worker has individual, personal insurance, it’s another piece of evidence that they’re not an employee and work for themselves.
Speaking of insurance, it’s a great idea to make sure that your business is also covered for any unlikely situation. If you’re unsure what type of insurance that you’ll need – you can find all the answers in this guide to business insurance for sole traders.
5. Submit your Status Determination Statement (SDS)
A Status Determination Statement (SDS) is a written statement stating the employment status of a worker.
An SDS should include how you have come to the classification decision and could list the supporting evidence to back up your claim. These statements also need to prove that you have followed IR35 instructions with ‘reasonable care’.
This means that you have to make a fair and well-considered decision that incorporates the following factors.
This looks at whether the contractor is required to complete the work personally, or if they have the right to substitute the work in order to meet demand. For example, an employee will be obligated to complete their work themselves, whereas a contractor could enlist help or outsource to complete a project.
Mutuality of Obligations (MOO)
This doesn’t just have the best acronym in IR35 but refers to obligations when accepting or offering work. With employees, they have an obligation to accept all work the company offers, and likewise, the company has an obligation to provide work for their employees. For contractors, this obligation does not exist.
Finally, this point looks at the level of control that the company has over the worker, including aspects such as setting work hours or working conditions. Contractors should have the freedom to set these conditions themselves and not be under the company’s control.
Once a Status Determination Statement is created it will need to be passed on to the worker and any other parties that are involved in this employment.
For example, if a contractor was hired from an agency, the agency would also need a copy of this statement to have agreement across all parties.
What else can businesses do to avoid IR35?
If you’re looking for other ways to stay compliant and learn how to avoid IR35, businesses can also consider the following three options.
1. Stop working with independent freelancers
One of the easiest ways how to avoid IR35 is to avoid working with independent contractors and freelancers entirely. If you don’t have any contractors, you can’t come under fire for incorrectly taxing them.
However, this isn’t a real solution. It’s avoiding the problem – and could potentially put your business at risk by turning away talented contractors and freelancers that you need.
2. Use CEST
CEST is HMRC’s ‘Check Employment Status for Tax’ tool, which you can find on their website here.
This tool is designed by the government to help you decide how to classify your worker’s employment status if you’re ever unsure. You can enter the details and information of their contract and it will return an employment status for your company.
All statuses that are given by this tool are used for official determinations and investigations, which you can keep as part of your own records. However, this only works as long as the details you entered are accurate. If there are any changes to the contract entered, then the results may not be accurate.
The downside of CEST is that it’s not the fastest tool or option out there and can be slow to return a decision. In addition, although you’ll get a result, you won’t get much support and won’t be able to use the result if any information you enter changes.
3. Buy an IR35 product or service
If you are still struggling to understand how to avoid IR35 and stay compliant, a lot of companies are offering dedicated IR35 products or packages so you can offload the work to someone else.
However, these solutions may be expensive and not worth the cost for some SMEs.
How to avoid IR35: a summary
IR35 is legislation that’s there to prevent employees from posing as contractors to avoid tax. Provided that you do not fall under this category, businesses can avoid paying unnecessary tax or be under fire for an investigation by:
- Making sure that you have a clear record and contract for your workers and ensure that they are not being treated or receive employee benefits;
- Create Status Determination Statements to determine the status of all your workers, which are then shared with all parties involved;
- Keep evidence of your worker’s classification.
And of course, if your worker does fall under the employee classification, you are then under obligation to follow IR35 rules and pay them through a PAYE system that automatically deducts tax and National Insurance payments.
For more business advice and news, keep up to date with Business4Beginners.