Contractors’ Questions: Can I beat IR35 by being a sole trader?

Contractor’s Question: I’ve read that IR35 deals with relevant engagements, and that no occupation automatically falls outside IR35. But isn’t it also true that IR35 can only ever apply to a person under a limited company, meaning an individual can entirely avoid IR35 by simply NOT being a limited company, but by being a sole trader instead? Though if this is the case, why aren’t most contractors looking to become sole traders?

Expert’s Answer: Technically, IR35 also applies when trading through a partnership, but as partnerships are the least used trading vehicle generally, let alone in the freelancing arena, we will concentrate on the difference between trading through a limited company or as a sole trader. 

Sole traders aren’t ‘IR35-caught’

Your question focuses on tax status. While you are absolutely correct that you cannot be ‘caught’ by IR35 if you are a sole trader, there are wider legal and commercial issues that need to be considered as well.  Nevertheless, I will start with tax and this may begin to explain why there a smaller proportion of contractors/freelancers operate as sole traders.

Let us assume that an end-client engages an individual operating as a sole trader to undertake a project over a relatively long time. At some point while work is underway, HM Revenue & Customs undertake a review of the engager’s records from a PAYE perspective. The Revenue notes that there are regular payments to that individual, and so asks about the nature of the work. The taxman then determines that based on the standard tests, referred to in the article you cite, of personal service, control and mutuality of obligations – that the relationship between engager and sole trader has all the hallmarks of an employer/employee relationship.

Sole traders aren’t immune to employee tax demands

HMRC’s view will be that the sole trader is in reality an employee for tax purposes of the engager and that the engager has failed to operate Pay As You Earn upon the payments made to that individual.  Assuming that the sole trader has paid over the self-assessment tax due on the profits he has made, then at the very least HMRC will be looking to recover the employer’s National Insurance Contributions (which currently would be calculated as 13.8% of the sums paid), plus interest because the NIC was not paid over at the correct time. Add on a penalty of at least 15% of the NIC due if HMRC can show that the engager did not take “reasonable care” to establish the correct status of that individual.  The final tax demand could run to several thousand pounds and comes on top of the accountancy fees and internal costs of dealing with the matter, let alone what might happen if the individual tries to subsequently sue for employment rights!

So, from this example, it is clear that engaging a sole trader is not necessarily an attractive option for an end user unless there can be confidence that the relationship is genuinely one of independent contractor and client. Of course, with there being so much subjectivity involved in a status dispute, there are no absolute guarantees.

Sole trader liability (from day one)

It might not necessarily be completely straightforward for the sole trader either; apart from the fact that a successful HMRC review might lead to the work being lost; many contracts with sole trader subcontractors include clauses which state that any costs and tax liabilities incurred by the engager as a result of a status dispute will be met by the sub-contractor; you.  Leaving aside whether such clauses are enforceable, there is a potential liability hanging over the sole trader from day one.

The status issue is actually turned on its head when the end-user engages a worker through a limited company; you cannot “employ” a limited company and so in simplistic terms, there can be no tax liability arising for the engager from any status challenge.  Let us consider the relationship that now exists:

Engaging Organisation – Limited Company Service Provider – The Worker

In this relationship, the worker is typically the shareholder/director of his/her own limited company, often referred to as a Personal Services Company (PSC).

The IR35 Intermediaries Legislation allows HMRC to look at this business relationship and create a ‘hypothetical contract’ between the Worker and the Engager.  Hypothetical, as no such contract exists, because:

• the Engager has a contract with the PSC (the “intermediary”); and
• the PSC has employed the Worker (with whom it may or may not have a written contract) 

Notional contract under IR35

However, HMRC have to determine as follows: if there had been a direct contract between the End Client Engager and Worker, would it have been a contract of service (employment) or a contract for services (self-employment)?

The tests used will still be those referred to, previously, and HMRC will still be seeking to argue that the Worker is an employee, albeit this time, a ‘deemed employee.’  But because the Engager is engaging a limited company (the PSC), the Engager cannot be the deemed employer and so the employment taxes burden falls upon the PSC.

As some have found out to their cost, the transfer of any status liability falls on the PSC and so, in reality, a liability for its shareholders - a very good reason why the Engager would prefer to engage with a limited company and another reason why it might be hard to get work as a sole trader.

Recruiters don’t touch sole traders either

We should now come on to the subject of agencies to answer your final question. There may be one or more agencies in the chain between the End Client and the PSC.  Due to the Agency Regulations, a recruitment agency can only supply staff and pay them as employees or engage with a limited company. The Income Tax (Earnings & Pensions) Act (ITEPA) 2003 (at s44-47) effectively prohibits agencies paying self-employed staff ‘gross,’ so the agency must account for PAYE where it engages with sole traders, which is of no benefit to that sole trader.  As most of the work in the freelance marketplace is only available through agencies, a sole trader is effectively closing the door on a great many opportunities, since recruiters won’t touch sole traders.

Even where agencies are not involved, there are many contracts from both national and local government sources where tenders will only be considered if the bidder has a limited company owing to the perceived protection offered to the engager by dealing with a limited company.  However, this protection cuts both ways and many people have set up limited companies as a means of limiting personal liability in the event that disaster befalls the business.

Limited company: more pros than cons?

The final reason why many freelancers prefer the limited company option brings us back to where we started – the tax benefits. Whilst the accountancy compliance costs of running a company may be higher, the opportunities for the shareholders to be remunerated by paying less tax and NIC are greater than the potential tax savings afforded to a sole trader.

So yes, if you trade through a limited company, you do have to ask yourself if IR35 applies to each and every engagement, which, of course, a sole trader does not.  But if you look at the matter on the basis of risk versus reward, it does seem that a contractor operating through a limited company suits the key players in the market - engagers and agencies alike - and in very many circumstances it may be the only way to get work.

The expert was Paul Mason, Contractor Division Manager at Abbey Tax Protection.