TL;DR
- IR35 determines if a contractor is genuinely self-employed or a disguised employee. Inside IR35 adds ~14% employer NI to your cost+14% cost
- Medium/large end clients determine IR35 status. Small companies (under new April 2026 thresholds) shift responsibility to the contractorClient decides
- HMRC can investigate 6 years of payments. Penalties range from 30% to 100% of unpaid tax6yr lookback
- April 2026: small company thresholds increase to £15m turnover / £7.5m balance sheet. More clients become "small"£15m threshold
💡Quick reference summary. Continue reading for comprehensive analysis and context.
IR35 is the single biggest compliance risk for agencies that use contractors. Get it wrong and you face retrospective tax bills, penalties, and interest going back up to six years. Get it right and you can engage contractors confidently, knowing your agency is protected.
This guide explains IR35 in plain English. No jargon, no legalese. We cover what it is, how to determine status, what your obligations are as an agency, the penalties for getting it wrong, and the changes coming in April 2026.
What Is IR35? A Plain-English Explanation
IR35 is a set of tax rules (officially called the "off-payroll working rules") designed to prevent "disguised employment." The idea is simple: if a contractor would be an employee if they worked directly for the client (without the intermediary of their limited company), they should pay similar taxes to an employee.
The rules look at the reality of the working relationship, not just what the contract says. HMRC examines three key factors: control (does the client dictate how, when, and where the work is done?), substitution (can the contractor send someone else to do the work?), and mutuality of obligation (is the client obliged to offer work and the contractor obliged to accept it?).
If the engagement looks like employment in substance, it falls inside IR35. If the contractor is genuinely running their own business and this particular engagement is just one of their clients, it is likely outside IR35.
Inside IR35 vs Outside IR35: What It Means for Your Agency
Outside IR35: the contractor is genuinely self-employed. You pay their company the agreed day rate. They handle their own tax through their limited company. Your agency pays no employer NI, no pension, no holiday pay. This is the most cost-effective way to engage contractors.
Inside IR35: the contractor is a "deemed employee" for tax purposes. The fee-payer (usually the agency) must deduct PAYE income tax, employee NI, and employer NI from the contractor's payment before paying them. This adds approximately 14% to your cost and eliminates most of the financial benefit of using a contractor.
| Factor | Outside IR35 | Inside IR35 |
|---|---|---|
| Payment | Gross day rate to contractor's company | Net after PAYE, employee NI, employer NI |
| Employer NI (agency cost) | £0 | 15% on deemed salary |
| Cost to agency (£300/day) | £300/day | ~£342/day |
| Employment Allowance | N/A | Cannot be claimed on deemed employees |
| Contractor take-home | Higher (tax-efficient extraction) | Lower (similar to employee net pay) |
For a full cost breakdown, see our contractor vs employee cost comparison.
How to Determine IR35 Status
HMRC assesses three main factors. No single factor is decisive — it is the overall picture that matters.
1. Control
Does the client control how, when, and where the work is done? If the contractor sets their own hours, works from their own location, and decides their own methods, this points to outside IR35. If the client dictates working hours, location, and approach, it looks more like employment.
2. Substitution
Can the contractor send someone else to do the work in their place? A genuine right of substitution (and evidence it has been exercised or would be accepted) is a strong indicator of outside IR35. If the client expects only this specific person, it looks like employment.
3. Mutuality of Obligation (MOO)
Is the client obliged to offer work and the contractor obliged to accept it? In employment, there is an ongoing obligation on both sides. A genuine contractor can turn down work, and the client has no obligation to keep providing it. Project-based engagements with clear end dates are stronger here.
HMRC provides the Check Employment Status for Tax (CEST) tool to help with determinations. Use it for every engagement and save the results. CEST is not perfect — it produces "indeterminate" results in about 15% of cases — but using it demonstrates "reasonable care," which reduces penalties if HMRC later disagrees.
Your Obligations as an Agency
Agencies sit in the middle of the supply chain between the end client and the contractor. Your obligations depend on whether the end client is classified as small or medium/large.
| Obligation | Small End Client | Medium/Large End Client |
|---|---|---|
| Who determines IR35 status? | The contractor's own company | The end client |
| Status Determination Statement | Contractor's responsibility | End client must issue; agency must pass to contractor |
| Operating PAYE (if inside) | Contractor's company | Fee-payer (usually the agency) |
| Employer NI liability | Contractor's company | Fee-payer (usually the agency) |
Agency as fee-payer
If there is no agency in the chain, the end client is the fee-payer. If there are multiple agencies, the one closest to the contractor is the fee-payer. The fee-payer bears the employer NI cost and PAYE operation for inside-IR35 engagements.
The Small Company Exemption
Small companies are exempt from the off-payroll working rules. This means the contractor determines their own IR35 status, and the agency has no obligation to operate PAYE or pay employer NI.
A company is "small" if it meets two of the following three criteria:
- Annual turnover not more than £15m (increasing from £10.2m in April 2026)
- Balance sheet total not more than £7.5m (increasing from £5.1m in April 2026)
- Not more than 50 employees
This matters because many of the agencies and end clients in the creative industry are small companies. If your end client qualifies as small, the compliance burden shifts entirely to the contractor. However, you should still satisfy yourself that the engagement is structured genuinely — reputational and commercial risks remain even if the tax liability sits with the contractor.
Penalties for Getting IR35 Wrong
HMRC can investigate up to 6 years of payments and charge:
- Unpaid PAYE income tax
- Employer NI at 15% on all deemed payments
- Employee NI (which you bear if you cannot recover it from the contractor)
- Interest from the date the tax should have been paid
Penalties on top of the unpaid tax:
| Behaviour | Penalty Range |
|---|---|
| Reasonable care taken (used CEST, documented reasoning) | 0% |
| Careless (did not take reasonable care) | 0–30% |
| Deliberate (knew it was wrong) | 20–70% |
| Deliberate and concealed | 30–100% |
The key defence is demonstrating reasonable care. Use CEST for every engagement, document your reasoning, issue Status Determination Statements, and keep records. If you can show you took the determination seriously and followed a proper process, penalties are significantly reduced — often to zero.
April 2026 Changes: What You Need to Know
Small company thresholds increase
Turnover threshold rises from £10.2m to £15m and balance sheet from £5.1m to £7.5m. More end clients will now qualify as "small," shifting IR35 determination responsibility back to the contractor. This is positive for agencies: fewer engagements where you bear the compliance burden.
New umbrella company obligations
End clients must ensure umbrella companies correctly operate PAYE and NICs. If you use umbrellas for inside-IR35 contractors, verify they are compliant. Non-compliant umbrellas could leave your agency exposed to tax liabilities.
HMRC enforcement focus
HMRC continues to prioritise IR35 compliance checks in the professional services and creative sectors. Agencies with multiple contractor engagements are higher priority for investigation than those with one or two.
Practical Risk Management for Agencies
IR35 compliance does not need to be complicated. Here is a practical framework that protects your agency without paralysing your contractor engagement process.
Assess every engagement before it starts
Run CEST before the contractor begins work, not after. Build it into your onboarding process so no engagement slips through without a determination.
Document everything
Save CEST results, keep copies of contracts showing substitution clauses, and record the working arrangements that support your determination. This is your defence if HMRC investigates.
Match contracts to reality
A contract saying "the contractor has a right of substitution" means nothing if the client would never accept a substitute in practice. HMRC looks at the reality, not the paperwork.
Review annually
Working arrangements change over time. A contractor who started on a defined project may gradually become integrated into the team. Review every ongoing engagement at least once a year.
Consider IR35 insurance
For borderline engagements, IR35 insurance (sometimes called tax liability insurance) can cover the cost of an HMRC investigation and any resulting tax liability. Premiums are typically £300–£800 per engagement per year.
IR35 Compliance Checklist for Agencies
- Maintain a register of all contractor engagements with IR35 status
- Run CEST for every new engagement before work begins
- Save and file all CEST results with date stamps
- Ensure contracts include genuine substitution, control, and MOO clauses
- Verify that contractual terms match the actual working arrangement
- Issue Status Determination Statements for medium/large client engagements
- Set up PAYE correctly for all inside-IR35 engagements
- Check end client size status against the small company thresholds
- Review all ongoing engagements annually
- Brief your team on what constitutes control, substitution, and MOO in practice
Frequently Asked Questions
What is IR35 in plain English?
IR35 is a tax rule that determines whether a contractor is genuinely self-employed or is effectively an employee. If the working relationship looks like employment, the contractor must pay similar taxes to an employee, and the agency as fee-payer must operate PAYE.
Who determines IR35 status: the agency or the end client?
For medium and large end clients, the end client determines IR35 status and issues a Status Determination Statement. The agency must pass this to the contractor and operate PAYE if the engagement is inside IR35. For small end clients, the contractor determines their own status.
What are the penalties for getting IR35 wrong?
HMRC can charge unpaid PAYE, employer NI (15%), employee NI, and interest going back up to 6 years. Penalties range from 0% (if you took reasonable care) to 100% (for deliberate concealment) of the unpaid tax. Using CEST and documenting your reasoning is your best defence.
What is the small company exemption?
Small companies (meeting two of: turnover under £15m, balance sheet under £7.5m, under 50 employees, from April 2026) are exempt from the off-payroll rules. The contractor determines their own IR35 status, and the agency has no PAYE obligation.
Does IR35 apply to sole traders?
No. IR35 only applies to contractors working through an intermediary, typically their own limited company. Sole traders are taxed on their income directly. However, HMRC can still challenge whether a sole trader is genuinely self-employed under general employment status rules.
Can I claim Employment Allowance on inside-IR35 contractors?
No. The Employment Allowance (£10,500) cannot offset employer NI on deemed employees under IR35. It only applies to genuine employees on your payroll.
How do I check IR35 status?
Use HMRC's CEST tool as a starting point. It asks questions about control, substitution, and mutuality of obligation. For borderline cases, consider specialist IR35 insurance or a professional assessment from an accountant experienced in contractor compliance.
What changes in April 2026?
The small company thresholds increase (turnover to £15m, balance sheet to £7.5m), meaning more end clients qualify as small. New umbrella company compliance obligations are also introduced. Both changes generally reduce the compliance burden for agencies.
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