What is the cost of IR35?

It’s nearly a year since the new IR35 off payroll working rules were introduced into the private sector, requiring all but the smallest of companies to assess their limited company contractors’ employment status for tax.

With much of the risk now passed up the supply chain, it’s not surprising we have seen more engagements being advertised as ‘Inside IR35’ -- requiring the worker to be taxed as if they were an employee.

IR35: Costings of captured and not captured

So, asks Chris Mattingly of WTT Consulting’s IR35 Navigator, what is the true cost for a contractor who has previously enjoyed the benefit of being ‘Outside IR35,’ now operating ‘Inside IR35’?

In the following examples we will compare how a contract invoice rate of £350 per day differs when advertised as either Outside or Inside IR35, and to keep things simple, we will set aside expenses and pension contributions to focus on how both outcomes can affect take-home pay.

Let’s start with...

Outside IR35 take-home pay 

Steve works as an IT consultant five days week, over 44 weeks.

So, for invoicing purposes, he will invoice his client £77,000 each year. 

Based on the new 2022-2023 tax rates and allowances, Steve, as his limited company’s sole shareholder, will take a small salary of £9,100, with remaining income taken in the form of dividends.

Allowing for a corporation tax deduction of £12,901, Steve will receive his £9,100 salary and total dividends of £54,999. 

With total income declared at £64,099, Steve will be required to pay £7,791 in tax through his self-assessment tax return. Overall, Steve will take-home £56,308, equivalent to £255.95 for each day worked.

Take-home pay when inside IR35 via a limited company

If Steve’s client determined the engagement was Inside IR35, the client would be required to treat the £77,000 invoiced as employment income and deduct £18,232 in income tax and £6,220, leaving a net payment to Steve of £52,548, equivalent to £238.85 for each day worked.

This means Steve is now £3,760 worse off each year! Moreover, he would need to increase his day rate to £380.12 (+8.61%) to take home an equivalent amount to his Outside IR35 engagement.

On top of these costs and adjustments, Steve’s client would be required to pay Class 1 Employer’s National Insurance and the Apprenticeship Levy (where applicable) on the deemed direct payment of £77,000, resulting in employer costs of £10,604.

In this scenario, both parties lose out, and HMRC gains, to the tune of £14,364!    

Take-home pay if inside IR35 using a PAYE umbrella company

As Steve’s client might not like the idea of paying employer costs, they might choose to terminate the contract with Steve’s limited company to then negotiate a new contract at the same invoice rate.

However, on this occasion they have decided not to engage limited company contractors at all, leaving Steve a choice to either contract through a payroll umbrella or find an alternative engagement. Steve chooses the umbrella option.

As Steve is now employed by the umbrella, the £350 day rate must now factor-in the employer-related costs, as well as the umbrella’s operating margin.

If we assume the umbrella deducts an operating margin of £1,200 each year (£100 per month), the umbrella will need to deduct a further £9,015 to meet its Class 1 Employer’s National Insurance and Apprenticeship Levy costs (if the levy applies to the brolly).

Steve has a gross taxable pay of £66,785, which after tax (£14,146) and Employee’s National Insurance (£5,888), leaves him with a take-home pay of £46,751, equating to £212.50 for each day worked.  Steve is now £43.45 (17%) worse off each day compared to being Outside IR35!

Steve may well be able to negotiate a better rate, but if he did, he would need to increase his umbrella day rate to £438.46 (+25.27%) to take home the same amount as his did when Outside IR35.

And the winner is...

If the client agreed to this, HMRC would now be a handsome £18,261 better off compared to when Steve was operating Outside IR35. So, I think we know who the winner is here -- in most of the situations that Steve faces, and that many other contractors face too!

Editor’s Note: For the purposes of this article, calculations are based on a taxpayer resident in England and Northern Ireland with a standard tax of 1257L who has not yet reached the State Pension age. All figures are annual and rounded to the nearest pound, unless stated otherwise.