Inside IR35 Limited Company – How does the accounting and tax work?

IR35 limited company

HMRC have had contractors in their sights for some time now but their most recent announcements look set to be the most significant. Changes to IR35 limited company contractors or “off payroll working” were delayed until 6th April 2021. HMRC have stressed that this delay is a result of the ongoing coronavirus pandemic and not a cancellation of their plans. The delay will give contractors working through intermediaries, recruitment agents and end clients more time to bring their affairs in order before the changes to IR35 limited company contractors are implemented next spring. 

This article will ensure you understand the basics of IR35, how inside IR35 limited company tax should be accounted for and how the upcoming changes will impact this.

This Article Contains

An Overview of IR35 For Contractors

IR35 is a term used to describe off-payroll working rules for clients, workers (contractors) and their intermediaries. These rules are not new in fact they were first introduced in the early 00’s. They were designed to prevent workers who would usually be classified as employees providing their services through an intermediary (such as a limited company) and enjoying the tax benefits that this brings.

Previously it was always accepted that the IR35 limited company contractor would determine whether the contract was inside or outside of IR35 which led to the majority of contractors declaring their contracts were outside of IR35 and continuing to operate through their limited company where they were able to offset expenses such as travel and subsistence then distribute the profits as a tax efficient mix of salary and dividends.

It’s no secret that for HMRC the legislation never had the desired effect of ensuring workers operating through intermediaries who would otherwise be considered employees under any other circumstances, pay comparatively similar amounts of income tax and national insurance as genuine employees and this is why we are now seeing big changes to the way the rules are applied.

What's Changing for IR35?

HMRC had originally planned changes to IR35 to be introduced from April 2020 however this was subsequently delayed until 6 April 2021 as a result of the coronavirus pandemic. 

The upcoming changes will now see the end client take responsibility for determining whether the engagement falls inside or outside of IR35. If the contract falls outside of IR35 then the contractor can continue to operate as they have done before via their limited company, receiving gross payment from the end client and paying corporation tax on their limited company’s profits after deducting allowable expenses. If the contract falls inside IR35 then the end client or fee payer (in the case of recruitment agencies) will be responsible for calculating,  deducting and paying income tax and national insurance liabilities. All of which will be deducted from the contractors gross payment apart from the employers national insurance which will be met by the end client or fee payer.

Status Determination Statements

When deciding whether an assignment is inside or outside of IR35 the end client will use the “check employment status for tax” service on the HMRC website. The end client will produce a status determination statement (SDS) and pass this onto the contractor and their agency. The SDS concludes whether the assignment falls inside or outside of IR35 and reasoning will be given for the decision.

If a worker or agency disagrees with the classification they can challenge the decision by raising it with the end client. According to HMRC guidance the end client then has 45 days to review the merits of the challenge and respond. During this challenge period the rules would be applied in line with the original judgement.

Small Business & Overseas Exemptions

These new rules have already been implemented in the public sector for some time. Their introduction to the private sector will see them apply to medium and large businesses only which means if the end client is considered a small business under the companies act 2006 then the responsibility for determining the IR35 status will remain with the personal service company.

The companies act 2006 deems a company to be small if any two of the following criteria are met:

– Annual turnover is no more than £10.2 million

– Balance sheet total is no more than £5.1 million

– No more than 50 employees.

In addition to this if a client is based wholly overseas then the new off payroll working rules will not apply and responsibility for determining IR35 status remains with the personal service company. A client would be considered overseas providing if it does not have a UK connection. It will have a UK connection if it either:

– is resident in the UK

– Has a permanent establishment in the UK.

This potentially leaves a number of situations where the contractor may still require the use of their limited company.

Contract Inside IR35 limited company - How It Works Currently

Assuming that the end client operates in the private sector then up until 5th April 2021 your personal service company is responsible for calculating and paying the employers national insurance liability to HMRC. You the individual will then pay the income tax and employees NI via your self assessment.

Inside IR35 limited company setups can still make use of one benefit. Up until this date you may still be able to claim the 5% expenses allowance before calculating tax due. When a contract is inside IR35 limited company expenses such as travel and subsistence will no longer be allowable but HMRC recognise your PSC will still incur some costs. This allowance is designed to account for expenses you incur whilst running your company such as accountancy fees and means both income tax and national insurance will be calculated based on 95% of the income received from the end client.

Just note that the expenses allowance may not exist from 6th April 2021 onwards but you can still make use of it in the 2020-21 tax year.

IR35 limited Company - Example

Lets look at an example that demonstrates  how the 5% expenses allowance is applied.

You’re working a 6 month contract for a private sector client that ends in December 2020. As this is private sector client it is currently the PSC’s responsibility to determine the IR35 status of the contract. In this example It is determined that this contract falls within IR35. The total value of the contract is £40,000. Now we can calculate the tax on 95% of the gross income:

Deemed value           £38,000              (£40,000 – 5% expenses allowance)

Employers NI             (£4,638)               (payable by the  company to HMRC)

Salary                           £33,362               (Salary is then subject to income tax and NI)

The salary amount is then declared on your self assessment tax return as employment income and will be subject to income tax and employee national insurance.

The limited company’s accounts will then look something like this:

Revenue                   £40,000

Salary                        (£33,362)

Employers NI          (£4,638)

Profit                         £2,000

The profit of £2,000 can be offset against any expenses the company incurs but as the contract is inside IR35 there will be stricter rules to follow regarding which expenses are allowable. If there are no expenses to offset then the £2,000 is subject to corporation tax and remains in the company until distributed to shareholders.

Inside IR35 Limited Company - Post 6th April 2021?

up until 5th April 2021 it is still the PSC who is responsible for determining the IR35 status of engagements so for the moment it’s business as usual. Beyond this date many contractors will continue to operate their personal service companies. There are many different reasons why this might be the case but the most common reasons are:

1.) They will be providing services to clients who are exempt from the new rules such as overseas companies and small UK companies. – In this case the PSC will determine the status of the contract. If it determines that the contract is outside of IR35 the company can operate in the usual way or if the contract falls within IR35 then it can continue to calculate and pay income tax and NI as in the example above.

2.) They are working multiple contracts – Remember each individual assignment or contract will be subjected to these new rules which means you may have some engagements that fall inside IR35 and some outside. The contracts that fall outside of IR35 can be handled more tax efficiently through the limited company.

3.) They want to maintain the flexibility that their limited company offers them, especially when working shorter term contracts – If their current contract falls inside IR35 but their next contract falls outside of IR35 they can easily pickup where they left off without the need to form a new company.

this video Explains Operating through your Limited Company inside IR35
9 mins

How Does The Future Look For Contractors?

It’s clear that the upcoming changes will have a significant impact on how many contractors operate. Especially inside IR35 limited company setups with  many asking how to avoid IR35 altogether but the aim now shouldn’t be to avoid IR35 but embrace it instead. 

Contractors of the future may find themselves working multiple contracts at the same time. Some inside and some outside of IR35. They may find that changing contracts results in them working outside of IR35 once again so it’s important that contractors stay ready for both scenarios.

For more information on IR35 for contractors and specifically IR35 for limited company contractors check out the Accountancy & Tax Academy – by Aidhan youtube channel where you’ll find a complete IR35 playlist.

 

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