IR35 explained — what every contractor and director needs to know

If you work through a limited company — or if your business hires contractors who do — IR35 is one of the most important pieces of tax legislation you need to understand. Get it wrong and the financial consequences can be severe. Get it right and you keep the tax efficiency that working through your own company is designed to provide.

This guide explains what IR35 is, how status is determined, what inside versus outside means in practice, and what is changing in 2026 that could affect thousands of contractors and the businesses that engage them.

What is IR35?

IR35 — formally known as the off-payroll working rules — is UK legislation introduced in April 2000. Its purpose is to counter what HMRC calls "disguised employment": situations where an individual provides services through a limited company intermediary but would, in reality, be an employee if that company did not exist.

From HMRC's perspective, a contractor operating outside IR35 can be significantly more tax-efficient than an employee earning the same gross income. A contractor can extract income as a combination of salary and dividends, keeping National Insurance contributions low. IR35 is designed to close this gap where the working relationship is functionally identical to employment.

The three main IR35 tests

Status under IR35 is not determined by a single factor — it depends on the overall picture of the working relationship. HMRC and the courts focus on three primary tests.

1. Substitution

Does the contractor have a genuine right to send a substitute to carry out the work? If the client insists on that specific individual and would refuse a substitute, this is a strong indicator of employment. A genuine, contractual right of substitution — backed up by real-world practice — points toward outside IR35.

2. Control

Does the client dictate how, when, and where the work is done? Genuine contractors set their own methods, hours, and working location. If the client controls the contractor's day-to-day activities in the same way as a manager controls an employee, this indicates an employment relationship.

3. Mutuality of obligation

Is the client obliged to offer work, and is the contractor obliged to accept it? Employment relationships typically involve an ongoing obligation on both sides. A contractor who can decline work — and a client who has no obligation to provide it — demonstrates a genuine business-to-business arrangement.

These tests are applied to the substance of the working arrangement, not just what the contract says. HMRC looks at working practices alongside the written contract. A contract that says all the right things, but where the day-to-day reality looks like employment, will not protect a contractor from an inside IR35 determination.

Who determines IR35 status?

This depends on the size of the end client — the organisation receiving the contractor's services.

Client type	Who determines status?	Who bears the liability?
Public sector	The client	The fee-payer (usually the agency)
Medium or large private sector	The client	The fee-payer (usually the agency)
Small private sector	The contractor's company	The contractor's company

Where the client determines status, they must issue a Status Determination Statement (SDS) to the contractor and the next party in the supply chain, explaining their decision and the reasons behind it. Contractors have the right to challenge an SDS they believe is incorrect, and the client must respond to any dispute within 45 days.

Inside vs outside IR35 — what it means in practice

If you are outside IR35

You continue to operate through your limited company in the usual way. You can extract income as a combination of salary and dividends, claim allowable business expenses, and pay corporation tax on company profits. The tax efficiency of contracting through a limited company is preserved.

If you are inside IR35

A deemed employment payment calculation applies. The income is treated as if it were employment income — subject to income tax and National Insurance — but without any of the employment benefits like sick pay, holiday pay, or pension contributions from the client. This typically results in a 15 to 25 per cent reduction in take-home pay compared to an outside IR35 position. You cannot pay yourself via dividends on income that falls within IR35, and your ability to claim expenses is significantly restricted.

HMRC's CEST tool

HMRC provides a free online tool called Check Employment Status for Tax (CEST). It asks a series of questions about the working relationship and produces a determination of inside, outside, or undetermined. HMRC will stand by a CEST result if the tool was used correctly and the facts provided were accurate.

CEST is a useful starting point, but it has limitations — it does not fully account for mutuality of obligation, and some genuinely nuanced arrangements return an undetermined result. For high-value or long-term contracts, a professional review of the contract and working practices alongside CEST is advisable.

What is changing in April 2026?

The definition of a "small company" for IR35 purposes is changing. From 6 April 2026, the financial thresholds to qualify as small — and therefore be exempt from the off-payroll working rules — are increasing. The new thresholds are:

Threshold	Previous limit	New limit (from April 2026)
Annual turnover	Up to £10.2 million	Up to £15 million
Balance sheet total	Up to £5.1 million	Up to £7.5 million
Employees	Up to 50	Up to 50 (unchanged)

A company qualifies as small if it meets at least two of the three criteria. Approximately 14,000 companies that were previously classified as medium will be reclassified as small, shifting IR35 status determination responsibility back to the contractor's own company for those engagements.

However, the practical impact is delayed. Because the IR35 size test operates by reference to the prior financial year, and there is a two-year consecutive test, most contractors will not feel the effect until the 2027/28 tax year at the earliest. If you currently work with clients in the medium bracket, monitor their size and plan accordingly.

What contractors should do now

Whether you are an established contractor, a new limited company director, or a business that engages freelancers, the key steps are the same: understand the rules, document your position, and review it regularly.

Specifically, you should review your current contracts and working practices to ensure they reflect genuine self-employment. Keep evidence — emails, statements of work, substitution clauses, working patterns — rather than relying on the contract wording alone. Run CEST and keep a record of the result. And revisit your position whenever you start a new engagement or when a client's circumstances change.

For businesses hiring contractors, the April 2026 changes are also an opportunity to review your IR35 processes. If some of your medium-sized clients will reclassify as small, your supply chain arrangements and IR35 procedures may need updating.

This article is for general information purposes and does not constitute tax or legal advice. IR35 status depends on the specific facts of each working arrangement. Please speak to a qualified accountant or tax adviser before making decisions about your contracting structure.