IR35 caused a big stir when it was introduced in 2021. Even today, 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 what happens if an employee is classed wrong under this payroll legislation.
Ready to begin?
What is IR35?
IR35 is not a brand new Star Wars character, but a piece of legislation designed to prevent tax avoidance by employees pretending to be contractors while reaping the benefits of an employee.
Also known as the ‘off-payroll working rules’, IR35 affects both public and private sector businesses. Whether you’re a sole trader or limited company, you must take on the sole responsibility of determining if IR35 applies to any employees or contractors that they hire.
This might sound simple, but if HMRC disagrees, they’ll be facing a hefty fine and investigation for tax avoidance.
What’s more, IR35 might mean a loss of contractors and a more difficult hiring process for these companies.
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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 the employee/contractor classification is 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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Disguised employee
A disguised employee is someone who 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 they and the company are claiming reduced tax rates that they aren’t entitled to.
If an employee is classified wrong
If 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.
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What is IR35 – A summary
In short, IR35 is a way to make sure that you’re not hiding any employees to avoid paying taxes. And because the government is pretty strict on tax laws, you need to make sure that you err on the side of caution with this one.
If you hire any freelancers or contractors, do not give them any treatment or benefits that employees receive. If you do that, you could come under fire for misclassifying your employees.
For more advice, view our blog on how to avoid IR35. Otherwise, come back for more news, tips and ideas at Business4Beginners.
